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New VC opportunities in the SBIR program

by contributor Alex Hecht, ML Strategies | Published April 27, 2012 at 1:39 PM

On Dec. 31, President Obama signed into law the National Defense Authorization Act of 2012. The NDAA included a six-year reauthorization of the Small Business Innovation Research and the Small Business Technology Transfer programs, which direct federal research and development dollars to small firms. Since September 2008, these programs had continued only through a series of 14 consecutive temporary extensions. The long-term reauthorization contained in the NDAA represents a major legislative victory in Congress that will provide much-needed certainty to companies that compete for SBIR and STTR grants in order to develop and commercialize innovative technologies and create new jobs in America.

The SBIR program was created in 1982 to increase the participation of small, high-technology firms in federal R&D efforts. Since the inception of the program, SBIR and STTR awards have provided small firms with $28 billion in federal R&D funds, and these firms have produced more than 85,000 patents, generating millions of well-paying jobs. Examples of SBIR's success include Qualcomm Inc. and Symantec Corp., companies that utilized SBIR funding to help grow into the technology giants they are today.

The long-term reauthorization also presents new opportunities for venture capital firms to participate in the SBIR program. For years, SBIR reauthorization had been thwarted in Congress mainly due to controversy surrounding the role VC should be permitted to play in the program. The recent reauthorization resolved the issue by specifying the eligibility of VC participation in the SBIR program, subject to certain parameters.

The original legislation authorizing the SBIR program did not address the role of venture capital. Thus, for the first two decades of the program's existence, venture-backed companies were able to participate in the SBIR program. This precedent underwent a major change in 2002 with a U.S. Small Business Administration policy directive stating that to be eligible for an SBIR award, a business had to be "at least 51 percent owned and controlled by one or more individuals who are citizens of, or permanent resident aliens in, the United States, except in the case of a joint venture." This directive provided a new definition of the term "individual," causing companies majority-owned by VC interests to be denied SBIR funding. One such company, Cognetix Inc., a Utah-based company majority funded by VC firms, appealed the denial of an SBIR grant to the SBA's Office of Hearings and Appeals. In 2003, the Office of Hearings and Appeals administrative law judge who ruled on the appeal found that, because VC firms were not "individuals" or "natural persons," companies in which VC firms held a controlling interest were not eligible to participate in the SBIR program.

The Office of Hearings and Appeals case generated a firestorm of controversy that was an underlying factor in Congress' inability to reach a long-term reauthorization of the program. However, following years of debate and months of negotiations between the Senate and House in the 112th Congress, a final SBIR reauthorization passed through the NDAA.

The new law reauthorizes the SBIR program for six years and includes language that permits small firms that are majority-owned by multiple venture capital operating companies, hedge funds or private equity firms to compete for up to 25% of SBIR funds at the National Institutes of Health, National Science Foundation and the Department of Energy. For other participating agencies, the threshold is 15%.

While the new law clarifies the degree to which VCs can participate in the SBIR program, the regulated community must still await the SBA's interpretation and implementation of several VC-related provisions. The reauthorization requires the SBA to publish proposed regulations within 120 days of enactment, and promulgate final regulations within one year, to implement the new VC provisions by determining what constitutes a small business as well as eligibility standards for the SBIR program. In this rulemaking, the SBA will address provisions related to VC participation, domestic ownership and "affiliation" -- the process by which the SBA determines whether an entity qualifies as a small business.

The new law also specifies that the regulations must permit participation of applicants who are majority owned by VCs unless the SBA determines that the SBIR applicant is a large business (or majority-owned or controlled by one) or is a foreign-owned business or a foreign entity and not a U.S. citizen. Finally, the law mandates that the SBA may not carry out the new VC-related provisions until it issues a final rule.

Passage of the SBIR reauthorization was a major victory for many stakeholders, including the VC community, and the upcoming SBA rulemaking will play a large role in determining the extent to which the VC community may engage in the program. Several key questions remain: Will the new statute and upcoming SBA rulemaking ultimately resolve the uncertainty for VC participation in the SBIR program? To what extent will VC participation in the SBIR program increase as a result of this new reauthorization? How will SBIR applicants react and adapt to the new rules for VC participation? Will the SBA be able to complete the affiliation rulemaking within one year, and what will happen if the SBA fails to meet this deadline?

For all of those reasons, it is essential that the regulated community remain engaged with the SBA and the administration through the notice and comment process. Venture capital and other private investors have long played a role in driving innovative technologies in the U.S. -- and soon will possess a greater opportunity to participate in the SBIR program.

Alex Hecht is vice president of government relations at ML Strategies LLC.

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