Thursday, August 27, 2009

A New Model for Venture Capital Investment in Tech Companies in Hawaii

The high technology investment tax credits under Act 221, as modified recently in Act 178, will sunset at the end of 2010. Already proposals are circulating among tech industry advocates for an improved tax credit scheme and/or separate tax credit bills tailored for different tech industries. However, I predict that there will be little interest in the State Legislature or the Governor’s Office for tax credit proposals to extend or succeed Act 221. The State faces declining tax revenues and budget deficits for years to come. The debate will continue whether the billion dollars of Act 221 tax credits claimed by 2010 will have provided commensurate benefits to the State. Hawaii tech investors, spoiled by tax credit multiple deals, are glutted and have become risk-averse. And the blowback from professional venture capital firms has been that Act 221 unduly skewed investment risk and value and led investors to seek tax deals over creating successful companies.

At the same time, it has been widely overlooked that the traditional venture capital model on which our companies have been funded is largely unsuited to their actual circumstances in Hawaii. The so-called “Silicon Valley model” works there because they have ample venture capital, robust tech industry synergies and business infrastructure, and a large pool of entrepreneurial talent and skilled techies. In the Silicon Valley environment, a company business plan based on being first-to-market and achieving exponential sales growth worldwide has a decent chance of success. In contrast, Hawaii has a business infrastructure based on agriculture, tourism, and real estate, our venture capital pool is small, our geographical isolation and lack of efficient transportation infrastructure imposes prohibitive costs on distribution and shipping, and our schools lag in graduates with business and technical skills competitive with the Mainland. In the Hawaii environment, a business plan based on exponential sales growth worldwide has almost no chance of success, yet almost all venture capital deals we have seen in the past keep “barking up the wrong tree”.

It is time that we put on our thinking caps and create a new model for venture capital investment more suited to our real circumstances in Hawaii. I advocate three major changes to the Hawaii venture capital model for tech companies:

1. Allow Act 221 to sunset, and implement the Act 215 State Private Investment Fund (SPIF) to be funded with up to $38 million in state tax credits that can be used to guarantee secured interest-bearing notes issued to lenders.

2. Have the SPIF act as a “fund-of-funds” to sector-focused tech investment firms required to raise 3:1 private equity funds to match SPIF investment, thereby multiplying by 4X the total investment pool available to invest in promising tech companies.

3. Encourage tech investment firms in Hawaii to shift away from the Silicon Valley model which has proved unworkable in Hawaii and toward the alternative R and D company model of direct monetization by tech transfer which plays to our strengths.

As for replacing Act 221, we already have a useful tax credit vehicle enacted with Act 215 in 2006 which, besides modifying the tax reporting requirements for Act 221 tax credits, also established the State Private Investment Fund (SPIF). Conceived as a “fund-of-funds”, SPIF is to be administered by the Hawaii Strategic Development Corporation (HSDC), a semi-autonomous agency under DBEDT. HSDC may issue up to $38 million of State income tax credits as authorized by the Legislature to guarantee repayment of loans and investments by external parties into an SPIF revolving fund. The SPIF revolving fund may then make loans and other investments to qualified tech investment firms to leverage their investments in portfolio tech companies.

For example, HSDC notes issued to lenders could be offered with a yield of say 4.5% cumulative over a 10-year term, repayment of which is guaranteed by state tax credits. In rough numbers $38 million cumulative at a 10-year maturity is equivalent to about $24 million in borrowed funds today. HSDC would then use the $24 million to sprinkle investments into a number of tech sector-focused investment firms. In the worst case, if all investments by all tech investment firms fail, then HSDC would be obligated to issue $38 million in tax credits to repay its lenders at maturity.

Since the notes issued on loans made to the SPIF would carry an attractive annual yield and are guaranteed for repayment with state tax credits, the pool of potential lenders would be expanded beyond individual accredited investors to mainstream sources of capital, such as banks, insurance companies, real estate companies, and annuity funds. This would ensure that the SPIF can be fully funded to the authorization limits set by the Legislature, and expanded if justified by performance.

As a fund-of-funds, the SPIF could require tech investment funds to raise say 3:1 in private equity funds to match its investment, thereby raising a total investment pool of $96 million. The SPIF can also target investment funds that focus on specific tech sectors in Hawaii and are managed by fund managers with specific domain expertise to better evaluate tech company opportunities and share their expertise with their portfolio companies.

The “third leg” of this prescription for a new venture capital model in Hawaii is to encourage tech investment firms in Hawaii to shift away from the Silicon Valley model which has proved unworkable in Hawaii. The Silicon Valley model is based on achieving a high valuation for an IPO or M&A exit by ramping up from startup to exponential sales growth. This is difficult if not impossible to execute in Hawaii with our constraints on venture capital, geographical remoteness, lack of distribution and business infrastructure, and small pool of skilled workers. Instead, most of the successful tech deals and investor exits in Hawaii, such as Verifone, Adtech, STI, Cheap Tickets, Digital Island, Hawaii BioScience and Blue Planet Wireless, were actually (although maybe not intentionally) accomplished by tech transfer to larger, more established companies that had the economies of scale and distribution channels to commercialize products and services successfully. None of these Hawaii exits left any permanent manufacturing, distribution, product sales, or service fulfillment jobs in the Islands. The investment capital used by those Hawaii companies to try to execute an exponential sales growth business plan was essentially a wash, whereas what the acquiring companies paid for were really their technology positions. So why not structure investment in Hawaii tech companies from the beginning based on monetizing technology positions through tech transfer? This is the alternative business model that I call the “R and D company model”.

The R and D company requires a smaller amount of investment and has lower business and market risk because its basic tasks are to protect its intellectual property (IP) rights, prove that the technology works, and develop a marketable product that an acquiring company can make profits on. Upon a successful exit by tech transfer to an established company, the R and D company can negotiate a grantback field-of-use license for Hawaii or preferred Asia-Pacific markets and parlay its newly acquired credibility and business alliances into venture capital funding of an ongoing Hawaii operating company that can credibly execute commercialization of the now-proven technology in geographically proximate markets. Tech incubators like Cellular Bioengineering headed by Hank Wuh and Oceanit by Pat Sullivan, and even individual inventors like Dr. Rob Yonover (author of "Hardcore Inventing"), are making good use of the R and D company model. New tech funds are also exploring focused investments in R and D companies, such as the State’s Hydrogen Fund managed by Kolohala Partners for investing in hydrogen research and infrastructure companies.

A typical R and D company in Hawaii can execute a tech transfer business model with funding in a range of $500,000 to $2 million, with the average being about $1.2 million. An exit can be expected in 5 or so years, with the first 3 years being directed to IP protection, technology validation, and product research and development, and the latter 2 years directed to technology marketing and licensing or sale negotiations. If there are no takers by then, there is seldom any need to drag things out. No second or third round of funding is needed. The tech investment fund can securitize their investment in portfolio companies with IP assets as collateral which can be liquidated through auctions or industry pools to reduce losses, or a new investor group may be found to buy out the IP assets from the previous investors. Among my clients that have used the R and D company model successfully, a typical tech transfer exit can provide a return in the range of about 4X – 10X to investor(s). On the upside, an R and D company that sells or licenses a technology position having industry-dominating significance can realize returns on investment in the range of 10X to 100X, comparable to returns on Silicon Valley IPOs and M&As.

The smaller amounts of funding required by R and D companies to execute a tech transfer business plan would enable the investment pool of $96 million of SPIF-backed investment firms to go much farther. If the average R and D company funding is about $1.2 million compared to an average of $5 million invested in Series A and B rounds to try to emulate the Silicon Valley model, then $96 million of investments in companies using the R and D company model could be made to cover 4 times as many companies as funding the Silicon Valley model. Because the R and D company model exit is based on tech transfer for value, these exits are more likely to be transacted, entail less market and business risk, and are therefore more likely to return overall value to the investment funds, thereby promoting their success and that of the SPIF fund-of-funds.

In summary, given what we have learned from the Act 221 experience and the realities of the Hawaii business environment that our tech companies work within, we should consider this new model for venture capital investment in tech companies in Hawaii. Funding an SPIF revolving fund under Act 215 through secured loans paying an annual yield guaranteed by state tax credits would open the pool for tech investment to larger and more mainstream sources of capital, such as banks, insurance companies, real estate companies, and annuity funds. Using the SPIF vehicle as a “fund of funds” would leverage larger private investment funds and provide a more effective use of state tax credits. Targeting SPIF investments into a number of funds each focused on a promising tech sector would concentrate domain expertise, spread risk, cover more innovation, provide more knowledgeable vetting of potential deals, and enable sharing of industry-specific management expertise with portfolio companies. Finally, instead of pursuing a Silicon Valley model that has not worked in Hawaii, we can reorient tech investment into R and D companies that require lower amounts of capital, have lower business and market risk, have quicker, more achievable exits, and can provide comparable rates of returns for investors.