COMMENTARY
It's time for modest reforms to Act 221
By Greg Kim, Barry Weinman, John Dean, Dr. Ed Cadman, Kenton Eldridge and Keith Mattson
The continuing debate on Act 221, which offers tax credits to high-tech businesses, distracts us from the real issue of how we can diversify our tourism-military based economy to include a significant high-technology sector.
There are compelling reasons to create a high-technology industry — one that's environmentally clean with high-paying jobs and global markets. It can create the next generation of companies that are vital to the community through leadership and charitable giving. It's time to step back and focus on a vision and strategy for Hawai'i.
Setting a vision
Professional investors in tech startups stress various criteria. Some will say "Give me a great management team," others will opt for a "great new product in a large market," some will focus on "intellectual property" and still others will focus on a "defensible strategy" (including such things as low costs and strong distribution).
Hawai'i is fortunate to have early-stage technology companies with these attributes. Not all will succeed.
If two or three out of every 10 succeed, that's a good rate. But to achieve this, all 10 startups must be based on solid foundations and pass investor scrutiny based solely on the merits.
From the rubble of failures will emerge a few successes in Hawai'i that can spawn accelerated job growth and spin-off companies. This is what occurred in San Diego with the successes of Hybritech (biotech) and Qualcomm (high-tech), which spun off nearly 100 other businesses.
Achieving a "home run" in Hawai'i — taking a company all the way to an initial public share offering or otherwise becoming a major global player — can be the vision and strategy. This can lead to the next crop of large companies in Hawai'i.
This is not to diminish the importance of smaller tech companies, but getting one or more Hawai'i companies to achieve global significance will accelerate growth in the industry and provide role models for many other companies.
Foster vision, strategy
Tax credits are one of the few ways that government can influence private investment decisions. Act 221 can jump-start Hawa'i's tech industry by helping Hawai'i investors overcome a fear of investing in technology startups.
But Act 221 should be a catalyst for sustained investment, not the end game. If excessively applied, Act 221 can undermine the tech industry. Act 221 has induced good investments, but it has also allowed investments that are entirely or substantially tax-motivated.
Risk is a key component of startups. It forces discipline and focus. Without risk, investors and entrepreneurs do not hone their competitive survival skills. They will either become wards of the state, continually requiring more tax benefits, or become starved for capital because professional investors who are not tax-motivated shun them.
In the interest of fiscal responsibility, Act 221 should be reformed to minimize the impact on state tax revenues consistent with achieving its objective and vision.
Act 221 reforms will help Hawai'i achieve the trust, transparency and integrity in our community that can attract top-tier talent and capital.
Prospective investors and employees from outside Hawai'i need to trust that any investment by a Hawai'i investor means more than the sale of tax credits.
Here are some Act 221 reforms that will move us in the direction of building a vibrant, merit-driven investment community:
• Set an Absolute "2X" Limit on tax credits.
Under Act 221, there is no limit in the multiple of tax credits that an investor can receive for every dollar invested. If the tax credits are too high, at some point the investor loses interest in the merits of the company. This is inconsistent with the vision.
High tax-credit multiples also hurt good entrepreneurs, who must compete with highly tax-leveraged deals that offer immediate profits to investors who receive $3, $4 or more in tax credits for every dollar invested.
So where should we draw the line? We believe permitting investors to obtain tax credits up to "2X" (a maximum of $2 for every dollar invested over a five-year period) strikes the right balance. Investors obtaining these tax credits still take meaningful risk in the investment and must still be convinced of the company's merits.
• Restrict related-party investments.
Under Act 221, a company can generate tax credits for itself or others simply by moving its existing technology expenditures and people to a related party, such as a wholly owned subsidiary. This may help explain the impact of Act 221 on the state's tax revenues. Even if some of these wholly owned subsidiaries and related parties are launching legitimate businesses, permitting related party investments provides too many opportunities for mischief and should be curtailed.
New Jersey's law for tech investment tax credits, which was the template for Act 221, requires such companies to obtain more than 20 percent of their equity from outside investors.
A similar requirement could help direct Hawai'i's precious resources to companies whose prospects have been evaluated by outside investors, and to companies that are willing to bring in outside capital to become global players. It would also put an end to tax schemes in which tax credits are manufactured from a company's existing cash revenues.
• Empower the state Department of Taxation.
Hawai'i tax officials need clear authority to challenge transactions that do not carry out the law's intent. Whether that means deleting the "liberally construed language" from Act 221 or clarifying the language, the department must be able to guard against such transactions.
Key ingredients
The state needs the best and brightest to take risks, create new businesses, generate high-paying jobs, and accept failure when it comes.
Many communities have tried different ways of achieving economic diversification with mixed results at best. It's hard work. It takes time.
Three key ingredients to achieve a robust technology industry are:
• Strong university research.
• Community support and mentoring for startups.
• A significant pool of investment capital.
Much has been done toward these objectives, and much remains to be done. We can refocus our resources and energies, fine-tune our existing strategies, and take the next big steps.
Act 221 has provided a great launching pad. Now is the time to make modest reforms to the law. By doing so, Hawai'i sends an important message that we believe our entrepreneurs can compete with any in the world.
Our audience includes not only those outside Hawai'i, but those within. We must believe in ourselves and instill confidence in Hawai'i entrepreneurs and investors to focus on value creation.
Let's invest in our future and not focus on manufacturing tax credits.
Greg Kim is a corporate attorney. Barry Weinman is a venture capitalist. John Dean and Kenton Eldridge are investors. Dr. Ed Cadman is dean of the University of Hawai'i's John A. Burns School of Medicine. Keith Mattson is director of UH Connections, a program to connect entrepreneurs inside and outside the university with resources they need.
