Tax-credit law stirs debate in high-tech industry

By John Duchemin
Advertiser Staff Writer

When Tracey Pettengill sought to raise money for her Internet company, 4Charity Inc., from Hawai'i investors in late 2001, she managed to attract more than $1 million.

But there was a catch. The local investors were interested in Pettengill's company not only for its potential as a high-tech company — but also as a tax shelter under Act 221, a 2001 Hawai'i law that lets investors claim state tax credits equalling 100 percent of their investments.

Worried about the risks of their investment, the investors demanded unusual precautions from Pettengill. Under the leadership of Hawai'i venture firm PacifiCap, the investors required 4Charity to set aside a portion of the investment in a "cash reserve account." The money, which Pettengill said was a significant portion of the investment, was not under full 4Charity control: It would only be released in increments over a one-year period, as the investors saw fit.

Pettengill now regrets signing the deal, which she said caused later potential investors to balk. PacifiCap partner Jeff Au, however, said the deal was clearly in investors' best interest — they would simply have more financial stability than typical venture investors who don't attach such strings to their money.

But the 4Charity deal, along with at least one other PacifiCap deal involving similar restrictive covenants, has turned into the epicenter of a debate over the use of Act 221 that is shaking the Hawai'i high-tech community to its roots.

A significant faction of venture investors, entrepreneurs, lawyers and other observers contends that the restrictive covenants represent a misapplication of the act. Cash reserve accounts and compliance contracts are not illegal, but their opponents argue that the act is generous enough on its own account, and that the use of unusual restrictions could not only choke the companies receiving the investments, but also give Hawai'i a bad name with the very U.S. Mainland investors the act was expected to attract.

"Senior Silicon Valley people I respect, and who are part-time Hawai'i residents, have told me that all Hawai'i companies could be painted by the same brush — not serious companies, just tax scams," said Barry Weinman, managing director of Palo Alto, Calif., venture firm Allegis Capital and board member and investor for several startup Hawai'i companies, in an e-mail.

Though Weinman acknowledged the use of cash reserve accounts was not illegal, he said the concerns over their use "are not understood by many well-meaning people (in Hawai'i)."

Act 221 is intended to stimulate the high-tech industry by drawing tax-interested investors to companies they may otherwise ignore. Not only does it let investors claim credits off their own investments, but it also lets consortiums of investors re-allocate credits and equity — so one group of investors could walk away with all the tax credits, while another group gets the lion's share of the company.

The act, which refined several earlier tax incentives, passed in 2001. It has drawn tens of millions of dollars in investments in local companies, but has also been the focal point of controversies revolving around its liberal wording, the use of the act by film productions, the lack of a cost-benefit study, and proposed amendments to the law.

The debate over restrictive covenants, however, is a different sort of controversy: It has divided members of the small, closely knit community of Hawai'i high-tech advocates, who disagree about how to make Act 221 serve high-tech Hawai'i's best interests.

On one side are those, like Weinman, who say that some Act 221 deals have shifted too much of the benefits of investment away from the companies and to the investors.

On the other are those who take a laissez-faire approach: Any money invested under the act is good for the economy, because it generates investments, jobs and general excise tax revenues that otherwise would not exist. PacifiCap's Au argues that deals tailored to protect tax-interested investors meet this standard.

Au founded PacifiCap in 2000 with current partner Rick Cho and former partner Theodore Liu, who in January was appointed director of the state Department of Business, Economic Development and Tourism by Gov. Linda Lingle.

The fund has used "compliance agreements," or contracts requiring a company to maintain Act 221 standing, in all 11 of its investment deals since the act passed. In other words, the companies have to remain in operation in Hawai'i for the five-year span over which the investors' tax credits would be distributed from the government — or their officers could be held liable for violating their contracts.

Au also said his firm has required cash reserve accounts in two of those investments: 4Charity and HotU, a Honolulu-based company that received a $2 million investment from a PacifiCap-led consortium in late 2001. Two former HotU officials confirmed the cash reserve was $400,000 — or 20 percent of the investment.

"If you put the tax credit aside, it's simply prudent, from an investor's standpoint, to have some financial discipline," said Au, a tax lawyer with degrees from Columbia and Stanford universities. "As an investor, would you prefer a company to call and say, 'Hi, the money just ran out and I have nothing left,' or one that calls and says, 'We didn't meet our numbers, but we have one or two months' cash in the bank?'

"If this was the boom years, maybe this approach would be too restrictive. But in this market, perhaps emphasizing financial discipline is a more prudent way to invest."

Charity's Pettengill said she agreed with the investors' reasoning when the deal was consummated. Now, however, she feels that the restrictions, while perhaps helpful to investors, were harmful to 4Charity.

"Remember, at the time, the law was brand new, and everyone was just trying to figure it out," she said. "At the time it was a good thing. But what became very clear was that (the cash reserve account) was not in the best interests of the health of the company, it was really in the best interest of preserving the tax credits."

With 4Charity still in fund-raising mode, Pettengill pitched the company to more venture investors in 2002 — only to find they were put off by the restrictions imposed by PacifiCap.

Charity ultimately failed to raise money in 2002. Pettengill isn't willing to attribute that entirely to the presence of the PacifiCap restrictions, but said "there was a definite negative reaction to it."

"They [investors] said it wasn't a healthy way to run the business," Pettengill said. "If you build the company in a healthy way, your equity will be worth much more to me than any tax credits would be.'"

Laurie Foster, the former president of HotU, also feels cash reserve accounts are unduly binding on a startup company. Startups are volatile and risky by nature, and their executives need the flexibility to use all their funds if necessary, said Foster, who negotiated the HotU deal with PacifiCap in December 2001 before leaving the company in April. Current HotU president Cathy Owen did not return phone calls for comment.

Several venture investors said that restrictions on a company's use of its own money go against the purpose of venture investing and could later cause would-be investors to balk.

"Every investor needs to understand that they're investing for equity, and that venture money is growth capital," said Kirk Westbrook, managing director of International Venture Fund, a San Francisco Bay area firm that was an early-round investor in several small Hawai'i companies, including both HotU and 4Charity.

"It's there to move the company forward, not keep it in business," he said.

Correction: The use of restrictive covenants under the Act 221 tax-credit law has become a point of debate in the high-tech industry. A headline on a previous version of this story incorrectly characterized the issue.