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Act 221

Is Hawaii's high-tech tax credit broken?

Our story begins with a loud and rancorous argument, but it doesn’t have an ending, yet. It’s either brimming with urban legend, or a classic Greek tragedy, depending upon who you talk to. Some see it as a battle for Hawaii’s future, and for the hearts and minds of our high-tech community and policy makers. The main characters are:

Photo Illustration: Stephen Goss

Barry Weinman, a part-time Hawaii resident, a venture capitalist since 1980 and the managing director of Allegis Corp., which has more than $600 million under active management.

Jeffrey Au, managing director of PacifiCap Group LLC, Hawaii’s largest venture fund with $30 million under active management. Au is an attorney by training and has been a Hawaii-based financial advisor since 1995.

Both men are active in the Hawaii high-technology scene. Weinman is the president of the business accelerator HiBEAM. In 2001, he and his wife, Virginia, donated $1 million to the University of Hawaii to endow the Barry and Virginia Weinman Chair of Entrepreneurship and E-business.

Jeffrey Au Photo courtesy: KHON-TV

In 2000, Au formed PacifiCap Group LLC with partner Rick Cho. A third partner, Theodore Liu, was appointed last January by Hawaii Gov. Linda Lingle to head the state Department of Business Economic Development and Tourism (DBEDT). Liu resigned from PacifiCap after the appointment, because the Hawaii Strategic Development Corp. (HSDC), an agency attached to DBEDT, uses state monies to invest in local venture firms, including PacifiCap Group.

The Au-Weinman conflict centers upon the long-term effects of Act 221, Hawaii’s historic tax credit for the high-tech and entertainment industries. Act 221 was enacted by the Hawaii state Legislature in 2001 to nurture the nascent high-tech industry through capital formation. It provides for a 100 percent tax credit (maximum $2 million) over five years for companies that invest in a Hawaii Qualified High Technology Business (QHTB). The law ends or “sunsets” in 2005.

Barry Weinman Photo: Ronen Zilberman

While much of the controversy surrounding Act 221 has focused on film deals, the issues run deeper and broader. In December 2002, Weinman and Au attended a meeting for Enterprise Honolulu’s Act 221 committee. The committee was formed to market Act 221’s investment opportunity and to rally the support of the high-tech community. Weinman was a co-chair at the time.

Accusations flew, tempers flared and the decibel level rose. Two days later, Weinman resigned. Weinman says, “I am on record for saying that the abuses of Act 221 need to be addressed very quickly. If they are not fixed, then I think the act should be repealed – it will soon do more harm than good.”

Au says, “The best defense to Act 221 and the best defense to all these urban legends is getting good companies funded and having good companies succeed. We’ve gotten a bunch of good companies funded this year.” He says that PacifiCap led the investment in seven Act 221-qualified companies in 2002. Those companies raised a total of more than $20 million.

Weinman, on the other hand, sees: “abuses” that are inconsistent with the intent of the law; deals with investors who get high multiples of their investments in tax credits; and complex financing structures, including investor-controlled reserve accounts and questionable subsidiaries. He says, “The abuses have people and tax-paying corporations thinking about tax shelters, not the quality of the entrepreneur and the upside of the startup’s equity.”

According to Weinman, “Some early buzz in Silicon Valley is that Act 221 is a tax scheme and that any company with Act 221 money is borderline dishonest and should be avoided.” He says Hawaii does not have a sufficient capital base and needs nonlocal investors, because it will take four to six rounds of funding for a company to go public. And if there is no serious local money to keep the companies here, Hawaii startups will eventually need to relocate to be closer to their later-stage investors.

Au says, “All of this talk that the Mainland investors aren’t going to like it, well, maybe it’s a nice theory, but it’s just factually untrue from the deals that we’ve closed this year.”

Venture Capital Terms
Burn Rate: The rate at which a startup company uses its venture capital before generating positive cash flow. The burn rate is usually defined in terms of cash spent per month. A burn rate of $5 million would mean a company spends $5 million per month.
Multiples: The ratio at which local investors exchange company equity for additional tax credits from U.S. Mainland investors. For example, a "5x multiple" would mean a person invests $200,000 and receives a $1 million write-off.
Series C Funding: A third-round financing event usually involving several private equity investors.
Upside: Potential for gain.

Weinman says three changes to Act 221 (either legislative or administrative) are needed to support Hawaii’s high-tech entrepreneurs: 1) cap the tax write-off at 200 percent or two times (2X) the Hawaii taxpayer’s investment; 2) no investor-controlled reserve accounts; 3) no questionable subsidiaries.

Au has a diametrically opposite analysis and a “free-market” outlook. He argues that, as a matter of policy, more tax credits are better. Generating high multiples of tax credits requires more out-of-state money. Au says Mainland investors are still vetting the deal. They still receive equity in tradeoffs, so that high multiples do not reduce the overall risk in the deal. The deal also does not cost the state more in the total dollar value of the tax credits.

Au’s partner at PacifiCap, Rick Cho, says the firm’s average deal is less than 2-to-1. Au says PacifiCap structured reserve accounts in two companies that it funded. These accounts were designed to slow the companies’ burn rates and contain enough to cover about one month’s operating expenses. The cash can be drawn upon under two conditions: 1) the company is solvent, having more assets than liabilities and 2) the company is QHTB-compliant. “What I find so ironic is that these things are specifically there to prevent abuse,” Au says.

A Case Study
Weinman’s Allegis Capital and Au’s PacifiCap Group are both investors in hotU Inc., a Hawaii startup. Weinman resigned from hotU’s board of directors in March 2002. HotU’s president, Laurie Foster, followed that April.

Foster remembers having to compete with other companies that were offering high multiples on tax credits in late 2001. She says, “I remember my first reaction was, ‘This is cheating. This is abuse. … And then somebody says, ‘You’re in a pretty good position, because you got a whole chunk of [investment] from the Mainland.’ And I said, ‘OK, fine. You do what you have to do.’”

She says Au then came up with the idea of a restricted cash account for some of the investment money. “That was a 100 percent safeguard for those tax investors,” Foster says. “I really don’t support it because you’re tying up money that the company can use.”

HotU’s President Cathy Owen sees the restricted account differently. “I haven’t found it inhibiting my ability to do my job or to grow out business,” she says. HotU did not do any fund raising in 2002.

Au says, “Reasonable people can disagree if this was the best thing to do or not. But clearly, that’s a private decision. It’s not something for the Legislature or the tax department, and it’s clearly not abusive.” He also says local and Mainland-based attorneys and accountants have reviewed hotU’s structures.

Owen says that through the subsidiaries, hotU’s $4 million series C round in 2001 was able to generate a total of $6 million in tax credits.

Owen says, “I think the one thing we’ve learned is that the structure we set up to be conservative has a tremendous amount of overhead to run three companies for being a small company.” She says if they were structuring the companies today, the setup probably would not be as complex.

View From The Trenches
One of the act’s architects, former state tax director Ray Kamikawa says, “… there is going to be growing pains, and people must recognize that. You do not condemn an initiative as far-reaching as Act 221 on the basis of a few vocal dissenting voices.”

PacifiCap is also an investor in 4Charity Inc., another QHTB. President Tracy Pettingill declined to comment on Pacificap. She did say, “There are people out there who are finding ways to use the tax credit opportunities in ways that are not necessarily in the intent of the law.”

Gregory Kim, head of the Hawaii Venture Lawyers Group says, “One of the things I’m really concerned about is if we try to appease the people doing these complex structures for whatever reason, we may even start losing people like Barry. … So, as a policy matter, what do we want the outcomes to be? The other way I think about things is: When the law goes away, which structure has the ability to continue under the traditional system?”

Issue Barry Weinman Jeffrey Au
Capital formation "The real issue is to figure out how to help Hawaii create a capital pool to support startups through at least two to three rounds of financing. There are few options – none of them easy." "Capital formation has two major components. One is to encourage local investors with cash to invest in the sector and two is to encourage investors from outside the state to invest in this sector in Hawaii. Of the two, which is more beneficial for the state? I would argue the latter."
High multiples of tax credits for investment Bad/Cap at 2X: "At 3X to 4X or more there is zero risk, so equity becomes unimportant. Therefore, no due dilligence is required and the worst companies -- those willing to give big writeoffs – get funded and quality, honest companies get starved for capital. Negative selection!" Good/Encourages out-of-state investment: "If you can adjust for the risk tolerances, you can bring the cash together and get more money for the company, so that's a good thing."
Investor-controlled reserve accounts No: Puts burden on company and CEO who may not have full access to amount funded. May be looked upon by sophisticated investors as a sham transaction to preserve tax credits. Yes: Has created them for two QHTB companies to slow burn rate with two conditions: 1) solvency and 2) QHTB compliance. Says it "prevents abuse."
Subsidiaries No: To subsidiaries that take existing cash from a parent and add a small amount of of highly leveraged tax-credit eligible investment, then reinvest very little new money (but generate a lot of tax credits) back in the parent. Yes: It's a business decision for management.
The bottom line on Act 221 "If people are genuinely concerned about creating a supporting environment for entrepreneurs, this is the No. 1 issue that needs addressing." No statutory changes. Private sector collaborates with administration on guidelines. "If you look at the capital that's been accumulated, you look at the companies that have gotten funded in the past two years, I think you see significant progress and the positives far outweigh anything negative."

Fuel-cell developer Hoku Scientific Inc. raised $1.5 million last year, without giving better than a 100 percent tax credit, no multiples. Chief Executive Officer Dustin Shindo says, “I know for certain that most of [the 17 investors] wouldn’t have invested if it wasn’t for Act 221, so it was a big part of it. But we didn’t match anyone’s investment. … I guess you could say we threw their [tax] credits away.”

Another startup, International Financial Services LLC, received $1 million in 2002. Randall Preiser, chief executive officer, says one local institutional investor got better than a multiple of four-to-one in tax credits. (A 5X multiple means if the investor put in $200,000, they got a $1 million write off.) “[Act 221] really helped us. It’s got us cash where we could have never got it before. There’s no two ways about it. It works,” he says.

Longtime Hawaii venture capitalist Bill Richardson, a partner in HMS Capital, says, “I think that it is a critical point for Hawaii to maintain its discipline on venture-capital investing.”

Rob Robinson leads the UH Angels investment group and holds the chairmanship at the UH organization that bears Barry Weinman’s name. He says the angel group has been investing on a straight 1-to-1 basis and probably invested a total of $2 million into Hawaii companies last year.

Robinson says while he’s generally against changing Act 221, he supports amendments that could add clarity. “It’s kind of like pornography,” he says. “Some people’s pornography is another person’s art. One person’s abuse is another person’s careful financial engineering.”

Some Of The Big Guys
Island Holdings Inc., the parent company of Island Insurance, was approached with about 20 deals last year. Island Insurance Cos. chairman and chief executive officer Colbert Matsumoto, says that the company’s private equity investments of around $2.5 million are about 1 percent of its assets. Matsumoto says the highest tax-credit multiple his company received on any investment last year was 4X, or 400 percent. The company has also invested on a straight 1-to-1 basis.

Matsumoto says he initially was skeptical about what he calls, “highly leveraged deals,” but has changed his views. “What’s happening is that more money is entering the private-equity marketplace from outside of Hawaii than might otherwise occur were it not for the fact that you have this kind of leveraged deal situation,” he says.

Island Holdings has also invested about $400,000 in creating its own QHTB subsidiary. Hoike provides a number of services to Island Holdings companies and outside companies, including software development and Web hosting. Hoike President Riki Fujitani says the company has about 30 employees. About one-third of its revenue now comes from outside of its parent company.

Another large local institution, AIG Hawaii, has begun forming its own QHTB subsidiary to develop software for the insurance industry. President Robin Campaniano says he would be interested if someone waived tax credits in his face, but so far has made no private-equity investments outside of AIG. Campaniano says, “We’re not interested in just making investments for the sake of generating tax returns, which is the way that a lot of people are hyping this right now. We’re more interested in looking at whether or not we can make a substantive investment in the QHTB we’ve developed.”

Island Holdings’ Matsumoto adds: “I think lawmakers have to be careful in how they approach changes in the law, so that if they tweak it or tighten it appropriately, they don’t throw out the baby with the bath water.”

Ultimately, Government Will “Fix” It, Or Not
Speaker of the House Calvin Say says, “(Economic Development chair Brian Schatz) just wants to give Act 221 a chance. I’ll support the chair at this point in just leaving it the way it is and having the department promulgate the guidelines for all applications.”

Sen. David Ige, chair of the Science, Art & Technology Committee says, “Is there a way to tweak the law and yet continue the momentum that has been started? I guess that’s the delicate balance that we’ll probably be taking up this year.”

Former state tax director Ray Kamikawa says, “I think we should permit the new administration to give us much-needed guidance.”

Gov. Linda Lingle had not yet appointed a tax director at press time, but deputy director Kurt Kawafuchi had created a draft of administrative guidelines for Act 221. Kawafuchi says, “If you do something, and you’re not really after the investment, you’re after just the tax credits and you get, for example, more than a 2-to-1 write-off, … then we have concerns about those credits.”

Kawafuchi says he’s looking at possible legislation, administrative guidance, promulgating rules and an audit program to tighten up the law. He says the state may disallow credits for investments that are found to be abusive.

He says not doing anything will cause Hawaii to lose credibility in the global markets. “If we try to curb the abuses, but we foster the legitimate investments and capital formation, I think we send a much better signal,” he says.

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