IP-BASED TECH-TRANSFER BY U.S. TECHNOLOGY COMPANIES TO CHINA

I just returned from a month-long trip to China touring with a U.S. law delegation under the Eisenhower Citizen Ambassador Program led by Deborah Enix-Ross of the law firm of Debevoise & Plimpton with 29 participants. We visited Chinese law firms, law schools, seminar forums, and bar associations in Beijing, Xi’an and Shanghai (photo of our law tour delegation which held a joint U.S.-Sino law seminar with the Lixiaohua Law Firm). Including my trip extensions to Hong Kong (SAR) and Shenzhen, China, I visited 10 Chinese law firms in 5 major cities. Meeting Chinese law professionals and seeing the economic development in cities first-hand since my last visit to China 20 years ago, I came away thoroughly impressed with China’s accomplishments to date and with its dynamism and optimism for the future. We Americans need to reset our held-myths about China from 20 years ago and realize that it is a completely different country today. While China’s Government is asserting its increasing strength and elevating stature in economic and foreign policy, it is transforming its domestic institutions to a society based on rule-of-law (under civil code similar to Europe) and free-market principles (tempered by practical controls over social order). China’s economic development in the past 15 years has lifted an estimated 300 million people of its current 1.6 billion population out of poverty, and managed a transition from a predominantly agrarian society to one where 50% of its people now live and work in cities. Whole cities populated in the millions have been built new. China’s goal over the next 15 years is to continue its transformation to a middle-class society, while it works toward a new social order in the world based on sustainable use of resources for needed economic growth. Its biggest challenge will be to continue to adapt its internal political system commensurate with its economic development.


One area providing a useful example of China’s development is in technology and its transformation to a technological society. In preparing for my trip, I came across an article entitled “Five Reasons China Will Rule Tech”, by Ray Kwong, published in Forbes Online, July 13, 2010. He notes that China's leadership places a high priority on educating its upcoming generations in science and engineering. Most of its Politbureau members including President Hu Jintao have engineering degrees. Its science and engineering pool is vast – in 2005 China awarded 351,500 science and engineering degrees, compared to 137,500 in the U.S. It now emphasizes an “indigenous innovation policy” to promote development of Chinese-origin technology while at the same time encouraging transfer of foreign technology and high-level management services to China.


U.S. innovation companies are typically small-to-medium sized enterprises (SMEs) lightly capitalized with venture capital. Such SME companies will find it increasingly difficult to compete head-to-head with Chinese companies. As an example, I came across an article entitled “Chinese Solar Giants Cast Shadow on U.S.”, by Todd Woody, Fremont, CA, published in the International Herald Tribune, Business Asia with Reuters, October 14, 2010. The article notes that in competing with Chinese companies, American technology companies are struggling to find niches where they can survive. Silicon Valley start-ups in Clean Energy like Solyndra, Nanosolar, and MiaSole are finding it difficult to make headway in world markets and even in the U.S. against low-cost Chinese manufacturers supported by government investments and favorable trade policies. The article quotes Conrad Burke, CEO of Innovalight, saying, “Innovation will be the heart of the U.S. [survival] strategy, and although it might not create the same scale, we are exporting well-protected technology to China and creating well-paying jobs here”.


In other words, American companies are finding that they can survive by transferring their innovation technology to Chinese companies to manufacture products at China’s low costs. If a joint venture is formed through Hong Kong or Singapore, which have strong rule-of-law systems, the U.S. company can provide licensing of reserved IP rights in China and technology and innovation expertise to optimize products for marketing in China, and earn license royalties or a revenue share of sales in China. The U.S. company can then import the low-cost Chinese-supplied products back into the U.S. and other markets where it retains IP rights for profitable sales of its own.


As outlined in my November 2009 blog article, U.S. technology companies can advantageously transfer or license IP (patent) rights as primary assets in IP-based tech-transfer transactions with Chinese companies according to the following model:

1. U.S. researcher invents a new technology, and applies for IP rights.

2. U.S. innovation company acquires inventor’s IP rights, develops and proves the feasibility of the new technology, and files for patent rights in the U.S., China, and other countries.

3. The U.S. company transfers or licenses the Chinese patent rights to a joint venture company which engineers the product and manufactures it for marketing and sale in China.

4. The joint venture company in China establishes the product at efficient manufacturing costs through domestic sales, then supplies the product at low cost to the U.S. company for import.

5. The U.S. company makes profitable sales in the U.S. and foreign markets where it owns strong IP protection rights.


The typical small-to-medium sized U.S. technology company has little leverage or sufficient resources to enforce Chinese patent rights against large companies in China anyway, so that a transfer to the Chinese joint venture partner is the best use of the China IP rights and provides an incentive to the Chinese joint venture partner to invest in engineering the product and gearing up for manufacture and sales in China. The U.S. company can control export of the low-cost product from China for sale in the U.S. and other countries such as Japan, Korea, Australia, Canada, and/or Europe by relying on strong IP rights there.


In a typical patent filing strategy, the U.S. company should file a home country (U.S.) patent application as soon as the invention has been completed, then file an international (administrative) filing under the Patent Cooperation Treaty (PCT) within one year in order to claim the U.S. priority date and extend the treaty deadline for foreign filings for a further 18 months while also receiving an early international search and patentability report. The U.S. company must then elect in which countries to file national-stage patent filings from PCT by the 30-month deadline (from the U.S. filing date), which would include China and any other foreign countries of strong commercial interest. The USPTO grants an export license for foreign patent filings automatically within 6 months of the U.S. filing date, unless the application is sequestered within that time for national security purposes. The U.S. company may need to apply for an export license to transfer related technology (such as software and engineering data) if they contain technical subject matter that goes beyond the scope of the patent application disclosure.


The challenge for a small-to-medium sized U.S. technology company in this IP-based tech transfer model will be finding a trusted Chinese joint venture partner and making a compelling business case why the product is likely to be profitable to them in domestic China sales as well as for export for foreign sales. Deal-making in China is still strongly dependent on personal relationships (“guanxi”), so an introduction to persons with decision-making authority in the target Chinese company will depend on going through well-connected intermediaries. In technology deals, such intermediaries may be bilingual business consultants and/or attorneys handling corporate and/or IP matters for the target Chinese company. Chinese companies have access to plenty of capital and no longer prefer to structure cross-border deals based on foreign investment. However, they still need to justify their access to domestic investment capital based on projecting a strong likelihood of profitable domestic sales.

THE BLUE REVOLUTION MANIFESTO FOR HAWAII

[The following is a manifesto for the launch of the Blue Revolution team in Hawaii, presently consisting of Patrick Takahashi, Leighton Chong, Guy Toyama, and Sheridan Tatsuno (SFO)]

WHEREAS, the State of Hawaii is located in the middle of a vast resource of the Pacific Ocean from which virtually limitless renewable energy, aquacultured seafood, desalinated water, electrolyzed hydrogen, and a cornucopia of biomaterials and other ocean-grown products can be sustainably harvested;
WHEREAS, the State of Hawaii under the International Law of the Sea Treaty has ocean boundaries constituting the largest exclusive economic zone (EEZ) of any other state of the United States and larger than that of many nations of the world;
WHEREAS, the State of Hawaii can build upon its unique assets in ocean research, strategic defense interests, commercial fisheries, traditional Hawaiian knowledge in aquaculture, and state and federal government agency support in order to develop technological advances, ocean engineering expertise, model regulatory policies, and industry best practices for knowledge transfer to and investment from other research institutions, organizations and companies in the United States and other countries of the world;
WHEREAS, the State of Hawaii has a golden opportunity to take a commanding leadership role in a new era of global ocean resources development, referred to herein as “the Blue Revolution”, which can create extraordinary growth in ocean resources industries, high-skill employment, and educational opportunities for upcoming generations of its citizens;
NOW, THEREFORE, WE SUPPORTERS OF THE BLUE REVOLUTION advocate the following initiatives and goals for respective participants, policy makers and enablers of ocean resources development in the State of Hawaii:
1. Have the Governor declare the State of Hawaii as a global coordinator for the Blue Revolution, making the proclamation on World Ocean Day in June of 2011.
2. Enact legislation to authorize and fund the State’s Department of Business, Economic Development & Tourism (DBEDT) to support ocean resources development as a Strategic Industry and draft a strategic plan for ocean resources development in the State of Hawaii.
3. Enact legislation to retitle the State’s Department of Land & Natural Resources as the “Department of Land, Ocean & Natural Resources” (DLONR), and authorize and fund an Ocean division of such agency with staffing and technical expertise for the regulation of ocean resources development in state jurisdictional waters.
4. Enact legislation to authorize and fund the Ocean division of DLONR to conduct and draft programmatic environmental impact assessments for the permitting of commercial operations in ocean resources development activities in Hawaii’s jurisdictional waters of the EEZ.
5. Invite, facilitate and provide incentives for investment, research, and pilot programs by research organizations, companies and other development partners in ocean resources development activities in Hawaii’s jurisdictional waters.
6. Provide state input and assistance to the National Oceanic and Atmospheric Administration in drafting a national marine aquaculture policy, and coordinate state actions with relevant federal government agencies for ocean resources development activities in Federal jurisdictional waters of the EEZ.
7. Enact legislation to authorize and fund the School of Ocean & Earth Science and Technology (SOEST) of the University of Hawaii to establish research partnerships with other universities, companies, and research sponsors in the United States and other nations of the world, and to publish reports on advances in ocean resources development in the State of Hawaii.
8. Set a goal for ocean resources development in the State of Hawaii to achieve installation of 1000 megawatts of ocean energy generation capacity by the Year 2030, with concomitant marine co-products, to include, but not be limited to, farmed seafood, freshwater, green materials, biofuels and hydrogen, ocean resorts and living communities at sea.
9. Set a goal of tripling (3X) Hawaii’s exports of ocean products and services within 5 years (2015) and generating a 100% increase in private sector jobs in these industries for Hawaii residents.
10. Set a goal of attracting of the order of $500 million of new local, mainland and foreign investment into Hawaii by 2015 to fund ocean resources business expansion.

THE BLUE REVOLUTION TEAM IN HAWAII

DRAFTING A FEDERAL POLICY ON OCEAN AQUACULTURE

(The following was co-authored with Patrick Takahashi, former director of the Hawaii Natural Energy Institute, and submitted as comments to the National Oceanographic and Atmospheric Administration for public input on drafting a national marine aquaculture policy.)

The role of marine aquaculture and its relevance to a safe, sustainable U.S. seafood supply has long been recognized. At the request of the then Administration’s Marine Fisheries Advisory Council in 2005, NOAA developed its 10-Year Plan for Marine Aquaculture in October 2007 to implement four distinct goals: (1) a comprehensive regulatory program for marine aquaculture; (2) development of commercial marine aquaculture and replenishment of wild stocks; (3) promoting public understanding of marine aquaculture; and (4) fostering increased collaboration and cooperation with international partners.

NOAA is currently seeking broad input on components of a draft marine aquaculture policy from interested stakeholders. Based upon review and public comment on its draft policy statement, NOAA will issue a new National Marine Aquaculture Policy.

The NOAA policy mandate applies particularly to Federal waters which extend 3 miles to 200 miles from shore. States currently have state regulatory jurisdiction over internal and near-shore waters up to 3 miles offshore. The United States has national sovereign jurisdiction over its territorial waters up to 12 miles offshore and extended jurisdiction in a 12-mile contiguous zone up to 24 miles offshore. Waters up to 200 miles offshore constitute the U.S. Exclusive Economic Zone over which it has regulatory powers and stewardship responsibilities, pursuant to international protocol under the United Nations Law of the Sea. The State of Hawaii, which is surrounded by ocean and formed of an island chain extending 1500 miles to the island of Midway, has the largest jurisdictional area of ocean water in the U.S. and contains one of the largest Exclusive Economic Zones in the world, with over 200,000 square miles of open ocean in its EEZ. Hawaii with EEZ, for comparison, would be twice the size of Texas.

World fisheries monitoring has long sounded alarm over the very serious and accelerating decline in wild fish stocks throughout our oceans. Projections show that with increasing world population and a shift of nutritional patterns away from red meat towards seafood, actual fish stocks, and hence world seafood production, could decline precipitously toward total depletion in the near future.

Aquaculture already supplies over 40% (70% from China) of global seafood production. Imports comprised over 80% of U.S. seafood supply in 2006, while U.S. production amounted to only about 460,000 metric tons. NOAA has estimated that annual domestic aquaculture production could be increased by 1 million metric tons by 2025. Similarly, due to declining wildstocks caused by overfishing, it is estimated that global aquaculture production would have to double within 20 years to meet the needs of a growing world population.

However, increasing commercial seafood production in the U.S. has been stymied by patchwork, ineffective and uncertain federal regulatory processes with overlapping jurisdiction applicable to marine aquaculture facilities, and by the need for additional research on environmental and socioeconomic implications of large-scale increases in commercial marine aquaculture. In a regulatory climate fraught with uncertainty, consumer and environmental fears tend to become exaggerated, and businesses will avoid risk to capital and not invest in developing marine aquaculture.

Aquaculture has long been practiced in internal waters such as fish ponds, rivers and lakes and in fish farms on land. The indigenous Native Hawaiians had developed fishpond aquaculture into a high form that sustained large populations even by today’s standards. However, limits on available land space and waters, as well as pollution and other environmental considerations, make expansion of on-shore aquaculture industries problematic. For example, at its height Native Hawaiian fishponds are estimated to have reached about 360 in number and supplied about 2 million pounds of fish for a population estimated at 500,000 or more, whereas today Hawaii has a population of 1.3 million and consumes about 50 million pounds of seafood per year, of which about 17 million pounds are imported.

Offshore marine aquaculture has become widely practiced throughout many countries of the world such as China, India, Indonesia, Japan, Thailand, and European Union. Hawaii is unique in the United States in having in place a system for permitting near-shore (within 3 miles) commercial aquaculture facilities. Two companies, Kona Blue Water Farms and Hukilau Foods (formerly Cates International) today operate in Hawaiian waters. Typical near-shore marine aquaculture facilities employ mesh cages or mesh enclosed pens tethered to the seafloor in which selected fish species are grown and harvested. However, these near-shore facilities have been criticized for using non-organic or antibiotics-laced fish food, generating fish food debris and wastes that cause downstream fouling, escapes and debris contamination of wildstocks, and attracting predator hazards to the near-shore environment.

New marine aquaculture technologies are under development to allow facilities to be sited farther in the ocean away from the near-shore environment. One example is the proposal of Hawaii Oceanic Technology, Inc., to deploy fully autonomous, submerged, self-positioning, OTEC-powered Oceansphere™ cages in deep ocean water. Its final environmental impact statement to operate submerged ocean cages 3 miles off the Kohala Coast of the Big Island was recently approved by the Hawaii Dept. of Land & Natural Resources. The company expects that operating farther off-shore in deep ocean water will avoid many of the environmental problems with near-shore facilities.

Floating island “ranches” for growing, harvesting, and processing seafood on an even grander scale operating far off-shore perhaps to the full 200-mile extent of the EEZ have also been proposed. As described in an article published in August 1999, “Ultimate Ocean Ranch, The Sea Technology”, by F. Matsuda, J. Szyper, P. Takahashi, and J. Vadus, such ocean ranches would use artificially-induced upwelling of deep-ocean nutrients in the open seas to enhance biological food productivity unencumbered by land-based or near-shore aquaculture limitations. Commercial-scale fish and seafood production would be managed on manned, OTEC-powered floating platforms. Such integrated facilities can be scaled to operate in a range from $3 million in aquatic food products produced annually from a 10 megawatt (MW) OTEC plant, to more optimistic calculations for a 1,000 MW facility producing $1 billion a year in seafood products.

It is clear that the U.S. must promptly undertake coordinating and adopting a national marine aquaculture policy and provide the funding, regulatory capacities, and needed research support for commercial marine aquaculture within the EEZ. However, due to a past practice of importing most of its seafood needs from abroad and reticence over environmental opposition to opening the EEZ to commercial operations at home, the U.S. policy has been long delayed and is basically starting from scratch. Hawaii’s near-shore permitting of two commercial aquaculture operations are currently the only domestic examples of commercial ocean aquaculture.

Environmental opposition to even these two Hawaii operations has provoked a call for a moratorium on further expansion of offshore commercial aquaculture. On the other hand, Native Hawaiian cultural opposition to commercial scale uses of Hawaiian waters has led to a call for the U.S. to support a return to onshore fishpond and traditional ahu’apu’a (mountain-to-sea) land use practices for food production. These environmental and cultural considerations in Hawaii have far less or only nominal significance to commercial aquaculture in deep ocean waters where the density of use of a commercial scale operation is tiny in relation to much larger ocean spaces. It is also apparent that Hawaii’s cultural and socioeconomic considerations will be different from other states that have shorelines, and from overall national interests subject to Federal jurisdiction and regulatory oversight.

It will therefore be an important foundational task for NOAA to differentiate its marine aquaculture policy into one part in coordination with state jurisdiction for near-shore (up to 3 miles) aquaculture, and another part subject to exclusive Federal jurisdiction for commercial scale aquaculture in Federal waters (3 to 200 miles offshore) in the EEZ. In the state-coordinated near-shore aquaculture policy part, NOAA can provide states with coordination of other relevant Federal agencies, monitoring capabilities, and research support. NOAA can also define a model state-coordinated program that states without near-shore marine aquaculture programs in place can follow. In the Federal waters aquaculture policy part, NOAA should exercise full Federal pre-emption of exclusive jurisdiction over Federal waters under a uniform ocean aquaculture policy.

Another important task for NOAA in establishing a national policy is to define an effective process, supported by well-reasoned considerations and science-based knowledge, for mapping permittable commercial marine aquaculture zones (MAZ) in the EEZ. Such mapping should identify and exclude trafficked, recreational, and environmentally sensitive near-shore areas, ocean transport lanes, defensive seas areas, feeding and spawning areas for extant fish wildstocks, and migration areas for fish, whales, etc.

It will also be an important task for NOAA to set up an effective and prompt, yet environmentally protective, lease permitting process for identified commercial marine aquaculture zones, including setting standards for content and scope of programmatic EISs for such zones, and EAs for applicant operators. Due to national economic interests, standards will also need to be set for applicant operators to qualify as U.S. nationals or U.S. owned companies, having adequate capital and track record for carrying out proposed operations, and fulfilling mandated responsibilities for such operations.

Rules for regulating operators and monitoring the impacts of their operations on surrounding areas will need to be defined by NOAA. Security and safety operations will need to be allocated between Federal authorities such as the U.S. Coast Guard, U.S. Navy, state and local authorities, and operators themselves.

Much of earlier monitoring work has been limited to tracking the decline of fisheries and focusing only on edible seafood commodities. The whole ocean resource development system needs to be better understood. Ultimately, next generation fisheries will need to manage large-scale deep-ocean upwelling and ocean thermal energy conversion effluents used by floating ranch platforms. It is imperative that the science and engineering of these systems be investigated now. NOAA should establish marine bioengineering centers for research study in the Pacific and Atlantic Oceans and Gulf of Mexico to establish the knowledge base for operating marine seafood and product plantations, growth cycles for open ocean systems, linking deep ocean and OTEC effluents to optimize productivity, and understanding the interplay of these programs with remediation of global warming, hurricane prevention or mitigation, sustaining ocean biozones, and other new fields of knowledge.

Therefore, in view of the considerable complexity of these policy drafting tasks and the considerable funding, agency expertise, and research support required, we recommend that NOAA consider the following Five Imperatives in drafting a National Marine Aquaculture Policy:

Imperative #1:
NOAA should differentiate its national marine aquaculture policy into a state-coordinated near-shore aquaculture policy part, providing state regulatory programs (within 3 miles offshore) with support in the form of coordination of other relevant Federal agencies, monitoring capabilities, and research support, and a Federal waters aquaculture policy part in which NOAA exercises full Federal pre-emption for exclusive jurisdiction over a uniform, national ocean aquaculture policy applicable to Federal waters (3 to 200 miles) in the EEZ.

Imperative #2:
NOAA must take leadership and apply the considerable regulatory expertise of its agency and of other extant federal regulatory agencies to balance environmental and socioeconomic concerns with business risk and feasibility in a timely, forward-looking policy document.

Imperative #3:
NOAA should develop its draft policy in close coordination with the U.S. Environmental Protection Agency and all other relevant Federal jurisdictional offices to create a one-stop organization capable of acting swiftly and substantively on lease permitting, qualifying applicant operators, evaluating environmental and socioeconomic impact statements and assessments, regulating operations, and monitoring impacts of commercial marine aquaculture facilities.

Imperative #4:
NOAA should provide advisory guidance to the Department of Commerce to identify and set aside Federal stimulus funds and future appropriations of Federal funds to jump-start the regulatory infrastructure for commercial marine aquaculture facilities. This will need to be coordinated within Congressional budgetary constraints and with U.S. Treasury and commercial lending organizations in a working partnership.

Imperative #5:
NOAA should develop its draft policy in close coordination with the Department of Agriculture, Department of Energy and the National Science Foundation to plan for and develop research capabilities in support of the development of the knowledge base for marine aquaculture science and technology.

Why Hawaii Technology Companies Should Consider Outsourcing Their R and D Work

Hawaii technology companies are typically underfunded with venture capital by 1/5 to 1/10 what Mainland competitors can command for a comparable venture proposal. The funding deficit for tech companies here has gotten even worse with the current recessionary economy, pullback of venture capital firms from startup funding in general, and collapse of Act 221 tax credit incentives for Hawaii investors. As a result, Hawaii tech companies with good research innovations may have insufficient funds to conduct the R and D work needed to validate proof-of-concept into a commercializable or licensable product. Even if they can accomplish this step, commercialization would be difficult to achieve given Hawaii’s underdeveloped business infrastructure and impediments to cost-effective manufacturing, distribution and shipping to global markets.

One promising avenue for Hawaii tech companies to bridge their funding deficit and achieve commercialization is by outsourcing their R and D work to foreign countries having professional workers with high STEM skill levels employable at low labor rates relative to those in the U.S. Many countries produce STEM graduates with skill levels comparable to ours, but at 1/5 to 1/10 the wage cost. Countries like China, India and the Philippines are especially attractive given that English is spoken universally by science and engineering graduates and by most educated businesspeople.

I recently toured a number of cities in the Philippines as part of a trade mission organized by the Filipino Chamber of Commerce of Hawaii. Besides promoting tourism to Hawaii and sister-city-state relationships with Philippine cities and provinces, the trade mission also explored possibilities for business relationships between Hawaii and Philippine companies. Business process outsourcing (BPO), such as for call-center operations, CAD and architectural drafting, medical records transcription, and data entry of written records, has developed into a major industry in the Philippines in recent years. With increasing technical sophistication, it is now moving into knowledge process outsourcing (KPO), such as agricultural field testing, medical clinical trials, IT programming, and ICT engineering.

A business model for a Hawaii tech company working with a Philippine partner might work like this:

1. The Hawaii tech company develops a new technology covered by U.S. and international patent filings, has a system design ready for testing, but has a small U.S. R and D budget.

2. A Philippine tech partner can do the field testing under an outsourcing contract on a wage scale 1/5 to 1/10 of the U.S. The Hawaii budget can therefore be stretched to encompass at least 2X or 3X more than can be obtained with the same budget in the U.S.

3. The Hawaii partner pays the contract price upon completion and assigns the technology rights and PI patent filing rights to the PI partner to exploit the technology in their own domestic PI market.

4. Successful exploitation by the PI partner in the domestic PI market validates the technology for sales or licensing in other countries in which the Hawaii partner holds strong IP rights, such as Japan, China, Korea, Hong Kong, Singapore, and Australia.

5. The Hawaii partner gains a tested system on a small budget and can exploit the product for sales or licensing in global markets. The PI partner can manufacture and ship the product for the Hawaii partner to nearby Asian markets at a much lower cost than from the U.S.

While corruption and cronyism may continue to impede foreign investment in established business areas like Manila, newly developing areas of the Philippines can provide a more conducive business environment for foreign investment. For example, the Subic Bay Metropolitan Authority (SBMA) is constituted to develop the 67,000 hectare former U.S. naval base as a Freeport and Special Economic Zone into a self-sustaining industrial, commercial, financial, investment, and academic center.

SBMA is only 100 kilometers from Manila and connected by the new SCT Expressway. It has complete deep-water port facilities and is only 24 hours sailing time to Taiwan, 28 hours to Hong Kong, 53 hours to Shanghai, and 70 hours to Kobe, Japan. Subic has an onsite international airport and is also only 45 minutes drive away from the larger Clark airfield that has large available capacity for international flights and airfreight. New condo buildings, trade office towers, university extensions, and affordable housing constructions are slated for completion beginning in mid to late 2010. Hanjin Industries of Korea has invested $2 billion in upgrading shipbuilding and port loading/unloading facilities, and Philippine contractors in manufacture and metal-working are lining up to provide skilled labor. SBMA will thus have state-of-the-art infrastructure for tax-free manufacture, assembly, and shipping of technology products to ASEAN and other Asian markets.

By outsourcing R and D work to suitable foreign partners in developing economic zones like Subic Bay, Philippines, Hawaii technology companies can overcome their funding deficit and have the necessary work done by their foreign partner leveraged several times more than what their budget could accomplish in the U.S. Further, by enabling their foreign partner to successfully exploit the now-proven technology in their own domestic market, the Hawaii tech company gains validation of the technology for sales or licensing in other countries in which it holds strong IP rights. The foreign partner would also be enabled to manufacture and ship the product to orders for the Hawaii partner to global markets at a much lower cost, and therefore greater profitability, than from the U.S.

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.

It’s Back-to-Business for Hawaii Tech Companies!

Well, it’s official. The Governor did not veto the Legislature’s Bill 199, so Hawaii’s Investor Tax Credit for investments in high technology companies has now been scaled back from an allowed multiple up to 200% to “only” 100% return of state tax credits to Hawaii investors, and the credits will now be claimable at no more than 80% of State income tax liability per year. Actually, the scaling back of benefits was not so bad. Rather, it was the way the whole tax credit program has been conducted over the past 10 years, reinforcing the perception that Hawaii is not a good place to do business. There is plenty of blame to go around on all sides, from the tech industry’s resistance to disclosure of jobs created and companies benefitted or to timely compromise to help the State close its huge budget deficit, to the Administration’s fecklessness in administering the tax program and articulating its support of development of the tech sector. This whole charade is mandated to sunset in 18 months anyway. Hopefully, the next iteration will be better conceived, supported and executed.

So, what now? The national economy remains in recession, trillion-dollar federal budget deficits will continue to grow, and the State will see declining revenues and negative growth in its mainstay real estate and tourism industries for years to come. If there is any desire of investors to invest in technology companies in Hawaii, they will be tight-fisted and very choosy over fewer deals. So is our tech sector doomed to wither and die? Not necessarily. Even in Silicon Valley, the new wave of tech investment is toward smaller amounts in more focused companies. Hawaii tech companies can thrive using an alternative business model in which smaller amounts of capital, possibly leveraged with research grants, are used to validate technology and secure IP rights that can be licensed, pooled or sold to more established, national or global companies that have the size and economies of scale to commercialize the technology in their industries.

This is actually not a new thing in Hawaii. Most of our successful tech deals and investor exits over decades have followed this model, although not by calling it the “R and D business model”, and often only when facing bankruptcy or business default. For example, Verifone pioneered its credit card POS technology in Hawaii, but moved to California for manufacturing and sales growth, in effect exporting its IP rights in patented technology to the Mainland. Hawaii Biotech also ended up exporting its IP rights in tropical vaccines to an Australian pharma company while retaining only a research presence in Hawaii. Ad Tech essentially sold its IP rights in broadband test equipment to Spirent, and Spirent now maintains a regional sales office here. Digital Island was acquired by U.K.’s Cable & Wireless essentially for its IP rights. BAE Systems bought STI’s patented hyperspectral imaging technology, and maintains a research office for its biomedical spinoff here. Almost all significant Hawaii tech deals have gone this route. That is why we continue to see good technologies developed in our university and DoD research labs, but no permanent manufacturing or product sales from the Islands.

In the alternative business model, the R and D company can secure IP rights in the form of copyright-protected software and media, patented invention rights, and/or licensable engineering know-how. It can monetize these IP rights by licensing, pooling or selling to established companies in the Mainland U.S. and globally. As a further option once its technology has been validated through licensing, it can seek the next stage of venture capital funding for spinning out a sublicensed company to commercialize the now-proven technology in local or regional markets.

The R and D business model can greatly reduce investor risk by focusing on technology validation and securing IP rights. This allows the constrained venture funding pool in Hawaii to fund more companies to develop more innovative technologies with the small amounts of venture capital available. The research activity also fits squarely within the qualifying guidelines for the 100% high tech investor tax credits in the next year and a half, which will help to reduce investor risk. So, far from gloom and doom, our R and D companies can now focus on their real business mission and hopefully thrive.

What Do Patent Attorneys Really Do?

My clients often wonder why they need a patent attorney? Many of them do a great job of documenting their inventions in writing, handing me 10-20 pages of written technical explanation complete with drawings. Why, they ask, do I insist on putting the invention description in a certain order, focusing on certain technical issues while ignoring their “big-picture” marketing verbiage, using certain buzz words like incantations, and keeping the drafting of patent claims off-limits to them? It is difficult to explain to each client while in the drafting process why patent attorneys do things in their mysterious ways. So as a general overview for technology developers, I will attempt to explain some of this mystery in layperson’s terms.

A Patent Is An Integrated Legal Document
This means that the patent document by itself must provide a complete explanation of the invention you are attempting to patent. It is also the document that establishes to the public exactly what you have invented. You will not be allowed to change or add anything material or to come in with a late explanation after the patent application is filed. If a crucial link in the chain of explanation is missing, the patent application may be rejected by the Patent Office for insufficient disclosure. Even if it is granted, the patent may be challenged by anyone over its 20-year term on the basis that something important for practicing the invention was left out or something you made a big point about turns out to have been erroneous or misleading.

It Must Define What Is New Over All That Is Old
The key to getting a patent granted and to defending its validity over its 20-year term is to accurately identify what is new over all that is old. What is old is everything that has been published in the U.S. and elsewhere in the world prior to your filing date. It does not matter that a prior product was not a market success, that a prior patent describes something obsolete when read 5 or 10 years later, or that a prior article or paper was not followed or endorsed in the industry. The Patent Office will use each prior art reference as indicative of what it teaches or suggests. If the inventor is an expert in the field of the invention, then the patent attorney should require the inventor to explain what was already known in their industry and how the invention differs from that. If the inventor is not an expert, it is advisable to at least have a patent search conducted. While patents are only a narrow slice of the world’s technical literature, companies tend to file for patents when something new is created that may have commercial value, so a patent search may be a good indicator of the state of knowledge in that industry.

Why Does The Patent Attorney Keep Repeating Things in the Application?
An experienced patent attorney is expert at identifying from a technical background description or a patent search what should be emphasized as being new about an invention. The patent attorney will repeat this in at least 3 different places in the patent application (Summary, Description, Claims) to make certain that the point is made. This is especially useful years later when the patent is challenged in court, and the attorney for the other side is showing many prior art references to the jury that were not found in patent examination to invalidate your patent. Because the patent keeps repeating what is new, the attorney defending the patent can more readily differentiate for the jury the invention over the prior art references by pointing to those sections in the patent that keep emphasizing what is considered to be new.

Why Is Comparative Test Data Needed to Support The Invention?
A patent must not only explain what is new about the invention, it must also present a strong argument why the invention is “non-obvious” over all prior knowledge. “Non-obviousness” is a legal requirement for patents that the invention not be something a person of ordinary skill in that field (an engineer) would have thought of given all that was known to be old. That is, the invention must be shown to involve a “discovery” or “leap of imagination”, not just routine engineering. This showing must be made in the patent application, or else a patent examiner may not be convinced and will reject the application. While the point can be raised as an argument later, the patent examiner will not allow you to read anything into the application that was not there as of its filing. Also, once examiners form an opinion as to obviousness, it may be difficult to dissuade them with late arguments. “Non-obviousness” can be shown by quantitative evidence of a critical difference or advantage that the invention obtains that the prior art does not. Comparative test data that illustrates this critical difference or advantage can be very persuasive. You can also show non-obviousness by showing how the invention solves a problem that the industry did not recognize, or takes an approach to problem-solving that is opposite from what the industry followed.

Why Does the Patent Attorney Ask for Other Versions of the Invention?
As they say in math, a point is only a singularity, two points make a line, three points make a plane, and four points make 3D space. If you show two different ways to implement the same invention concept, the examiner and the public can infer that you are entitled to patent all other versions lying between those two, or three, etc. This shows that you are entitled to a broad reading of your invention claims. Also, if the patent examiner finds a prior art reference in examination that knocks out one of your versions, then you can shift your patent claims to focus on the other version and still get a patent granted.

Why Is It Important to Show Each Step in the Invention System or Method?
The basic exchange for a patent is that the Government grants you a 20-year monopoly on specific technology, but you must teach the public (in the patent document) how to implement that technology without the public having to guess about it or to invent it for you. In this manner the progress of patent filings records, and therefore advances, the progress of technology. You are not allowed to hold back the critical linchpin that makes the whole thing work, or to leave out the “secret sauce”. If you do, the patent may be challenged at any time as invalid. You do not have to describe every detail of other parts that are not what is new about the invention. But if you are asserting what is new, then you must specify each step that you have conceived to implement it.

What If My Development of the Invention Is Only At the Prototype Stage?
Every patent filing is a snapshot in time that becomes dated by the end of its 20-year term. You can assume that this will be the case. No one expects an inventor to describe an implementation of the invention that will still be in use 20 years from now. However, what you do describe in the patent as the invention must be complete enough in design and operation that the public can understand by reading the patent how to implement the invention, even if they may use other components later that perform the equivalent function. The trick is knowing when an invention has been completed in conception and reduction to practice, even if it exists now only as a prototype. This is where the patent attorney’s judgment is important. If a critical step of implementation is missing, the patent attorney will flag it as a place for you to fill in.

Why Do I Need to Describe the Nitty-Gritty Details? Will I Be Limited By Them?
Patent attorneys like to build at least one, if not more, technical “fallback” position into the patent application. That is, if the examiner in patent examination finds prior art that shows or suggests your overall invention concept, your broad claims may be rejected. However, if there is a more specific implementation detail not shown in the prior art that is described in your example of the invention, then you may be able to narrow your patent claims to limit the definition of your invention to that particular form of implementation, and thereby still get a patent. The patent claims are separate from the description of the invention. You are entitled to the broadest patent claim on your invention that does not overlap on what is old (the prior art). So the nitty-gritty details described in your example do not limit you. They are only there to afford you an option to narrow your patent claims if prior art is found that knocks out the broad concept of your invention.

Why Does the Attorney’s Patent Claims Sound So Weird?
Patent claiming is a true art form, and is the main reason to justify why you hire a patent attorney. It is the first part of a patent attorney’s training. The patent claims are written now, but hopefully will cover the many ways others may want to use your invention 20 years into the future and with other components developed in the future. To do this, a patent claim must be drafted as a fine balance between defining enough specific and definite details that the invention can be differentiated from the prior art, while at the same time it must not include any unnecessary language that limits the patent coverage in ways that are not essential. Basically, the patent attorney must craft the claims to include only necessary details and omit all unnecessary details, and do this while guessing how things may change in the future. In addition, patent claiming must follow a number of rules of formatting, such as: (i) a patent claim must be written as a single nominative phrase (I claim a …); (ii) "comprising" means "including, but not limited to", whereas "consisting of" means "including these only and no others"; (iii) a term cannot be indefinite as to what it specifies (… an applet … (not a widget and/or an applet)); (iv) indefinite articles are terms of inclusion (an applet … including an applet pair), while definite articles are terms of exclusion (said applet … (and no other)); etc. These drafting strategies and rules are designed to make parsing what a patent claim covers or does not cover 20 years into the future an exact process that minimizes uncertainty.

Hopefully, the above will enable you to understand what your patent attorney is doing, and why these fine points may be important for your patent over the long term.