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SBIR Parent ‘Discriminates’ Against Select Small Businesses, VC Group Head Contends

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The US government agency responsible for regulating the Small Business Innovative Research grant program “discriminates” against certain private companies, enacts “irrational and unjustified” policies, and perpetuates a “significant injustice” against US innovators, including life science entrepreneurs, according to the president of the National Venture Capital Association.
 
Mark Heesen made his comments last week in testimony before the US House of Representative’s Committee on Small Business, which met to review legislation to re-authorize the SBIR program.
 
The committee’s legislation includes changes to existing SBIR eligibility rules made in 2003 that disqualify small businesses from the program if 50 percent or more of their ownership comprises venture capitalists. This rule, which is part of funding regulations set to sunset Sept. 30, is “inconsistent, discriminatory, and based on serious misconceptions [of the venture capital industry and] which [the Small Business Administration] appears to have absolutely no interest in re-examining,” Heesen said in his testimony.
 
By comparison, the committee’s legislation, which includes a provision that will “once again” allow VC-backed companies to participate in the SBIR program, can help “bring a steady stream of innovation to the market and support small businesses,” he said.
 
He added that disqualifying VC-backed businesses “is a disservice to our country” and stressed that the NVCA will not support the re-authorization of this program” if the inclusion provision is removed. His complete testimony is available here.
 
At the hearing, held in Washington, DC, SBA Administrator Steve Preston defended the existing rules and suggested that investing in companies supported principally by venture capitalists would be unfair to small businesses that rely solely or principally on government funding.
 
Preston, whom the committee was forced to subpoena after “multiple attempts” to secure his participation failed — making him the first SBA head to appear before the panel in such a way — testified that his agency “is concerned with the proposed legislative change to the definition of small business for the purposes of venture capital investment.”
 
“While recognizing that venture capital investment is crucial to small business growth,” Preston said that the SBA is “nevertheless concerned that … any redefinition that alters the elements of independent ownership and control that identify small business ownership under current law has the potential for great harm to all small business programs.
 
“The option of expanding [VC] participation raises a number of issues,” Preston testified. “For example, exempting VC or other institutional investors from affiliation in size determination could affect the transparency needed to determine program eligibility as well as the intent of the program to benefit businesses that are small. Further, any changes to SBA’s size standards could potentially affect SBA’s other programs.” He did not elaborate.
 
Preston added that “along with a numerical measure of the size of business” — its capital structure, for instance — “the Small Business Act includes the criteria that a small business must also be ‘independently owned and operated.’ Without a consideration of affiliation, Federal assistance targeted for small businesses could be inappropriately provided to a business concern that is part of a large business.
 
“Any redefinition that alters the elements of independent ownership and control that identify small business ownership under current law has the potential for great harm to all small business programs,” Preston added without elaborating. His complete testimony, which runs to four pages, can be viewed here.
 
The Small Business Committee appears to have sided with NVCA’s Heesen. In a statement released following the hearing, Committee Chairwoman Nydia Velázquez (D-NY) said the legislation that she sponsored “increases the number of firms eligible to participate in SBIR and erases the barriers many entrepreneurs face in accessing R&D capital.”
 
The bill, which must still be presented to the full House, “expands the range of small businesses that can participate in the program … provides them with technical assistance, and allows entrepreneurs to leverage private sector funding,” Velázquez said.
 
Referring to the rule that disqualifies certain VC-backed small businesses, she said the SBIR program “remains out of step with the realities of today’s technology-centered world.”
 
Heesen noted that Velázquez’s legislation “incorporates the same [venture-capital] safeguards” as H.R.3567, the Small Business Investment Act, which passed the House last fall with a vote of 325 for and 72 against — an “overwhelming bipartisan margin,” he said.
 
‘Manipulating the System’
 
To be sure, the SBIR program has “encouraged” recipient companies to receive VC investment since the program was founded in 1983, according to Preston. Indeed, existing rules say that more than one venture-capital company may invest any amount of money into a small business that receives SBIR funding, “with the only restriction that they cannot in concert own more than 49 percent and/or have the ability to control the SBIR awardee.”
 
In addition, “if a venture-capital company is for profit” — leaving open [the question of] whether there ever was one that [didn’t] seek a profit — and is owned at least 51 percent by one or more individuals who are US citizens or permanent resident aliens, [the VC shop] may own more than 49 percent of the SBIR awardee “so long as the awardee and its affiliates (including the VC and its affiliates) have no more than 500 employees in total.”
 
According to Heesen, these metrics are based on “irrational and unjustified” — but not entirely ignorant — premises. Heesen said, for instance, that among the “myths” the SBA maintains is that “venture-backed companies do not need SBIR programs because they are strong, fully funded entities,” Heesen testified.
 
“Make no mistake: the venture-backed companies that apply for SBIR grants are the epitome of small, fragile businesses,” he said. “These entities typically employ less than 25 people, and are comprised of just a few individuals who have developed a promising innovation that they wish to bring to market.
 
“The only distinction for a venture-backed company is that it has demonstrated enough promise to attract an investor whose business it is to find and fund opportunities ready for commercialization,” said Heesen.
 

The SBA “in reality … knows this, which is why they have gone to great lengths to manipulate the system and concoct a nonsensical formula to justify their position.”

“Even with venture capital investment, the road is long and difficult,” Heesen said. “These companies are extremely high risk and have the same chance of failure as their non-ventured counterparts. Contrary to the SBA’s premise, venture-backed companies do not have access to a bottomless pit of funds. In fact, the financial controls at a venture-backed company are perhaps more stringent than those without this oversight.
 
“Perhaps SBA believes venture-funded companies have unlimited cash because they believe venture firms have unlimited cash,” he suggested. “That too is a fallacy. Venture firms raise capital in a closed-end process. Once the fundraising cycle is complete, venture firms have a contractually finite pool of resources with which to help grow a dozen or more companies — and those resources have to last 10-12 years.”
 
Casting a blow to the belief that small venture-backed companies can afford to bypass private equity in favor of government funding, Heesen said that 0.4 percent of extramural grants from the National Institutes of Health went to businesses. Most money, he argued, went to higher education and research institutions instead.
 
“If there were other avenues to obtain these much needed funds [then small businesses] would have found it by now,” Heesen stressed.
 
According to Heesen, the SBA also “wrongly assumes” that venture-capital firms are large corporations and, therefore, the companies that they fund “should be excluded from consideration from SBIR grants.”
 
In September 2007, SBA’s Preston testified before the House Small Business Committee, which was reviewing another bill that would allow VCs to participate more in SBIR-backed companies. In that testimony, Preston said that “while SBA encourages venture capital investment in small business we must object to [a provision that] would allow a large business to own and control several small businesses without affecting the size status of the businesses.”
 
According to Heesen, the NVCA “agree[s] that large corporate-owned businesses should not be allowed to participate in small business programs. But venture capital firms are not large corporations with deep pockets and ulterior motives.
 
“They are almost entirely private partnerships that are typically comprised of less than a dozen professionals,” he said. “And if the SBA considers a dozen professionals to be equivalent to a large corporation, then almost every business they support is out of compliance.”
 
Heesen maintained that the SBA “in reality … knows this, which is why they have gone to great lengths to manipulate the system and concoct a nonsensical formula to justify their position.”
 
Heesen described a scenario in which one of its members testified before the Small Business Administration Committee and described how one of its “small” portfolio companies was “denied a small business waiver” from the SBA for a $900,000 FDA application fee.
 
According to Heesen, the undisclosed company employed seven people, but the SBA counted every employee from the venture-capital firm, which employed fewer than 10 staffers, and every company in the venture portfolio, which combined exceeded the 500-employee threshold listed in the 2003 capital-structure rules.
 
“Aside from this maneuver being absolutely irrational and unjustified, the SBA hurt a very small business and delayed a very promising drug discovery,” Heesen said, without elaborating.
 
The SBA also “wrongly assumes” that venture-backed companies are controlled by venture capitalists, said Heesen. While venture capitalists as investors “typically” sit on the boards of their portfolio companies, they “do not exert day-to-day control of a company” because a fund manager divides his time between all of his investments “and it would be impossible and impractical to spend that limited time on the nitty-gritty, day-to-day decisions that the internal management team must make instead of helping the management team make the strategic level decisions necessary to grow,” Heesen explained.
 
Lastly, Heesen pointed to a National Academies of Science study that debunked the notion that VC-backed small businesses that win SBIR grants take from the mouths of their non-VC-backed counterparts.
 
In fact, the NAS report found that there are “useful synergies” between venture-capital investment and SBIR funding in terms of selecting the most promising companies.
 
“During the first two decades of the program, when participation of venture funded firms was not at issue, some of the most successful NIH SBIR award-winning firms were able to perform at high levels because they were allowed to receive venture funding as well as SBIR awards,” he said. “By discriminating against venture-backed firms, the SBA is removing some of the most worthy applicants from consideration.”
 
Small-Business Upshot
 
How the existing rules have affected venture-capital financing in recent years is up for debate.
 
Jo Anne Goodnight, SBIR/STTR coordinator in the NIH’s office of extramural research, testified last June at the House Science and Technology Committee’s Subcommittee on Technology and Innovation hearings on SBIR and the Small Business Technology Transfer program.
 
During here testimony, Goodnight said that the number of new small businesses participating in the NIH SBIR program has been decreasing since 2003 with only about one-fourth of the awardees being new to the program in FY 2006. This number, she added, is the lowest proportion within the last decade [see BTW 7/2/2007].
 
Four months later, Heesen, speaking at the University Startups Conference in Bethesda, Md., said that after a relative lull in VC investment in university startups in the past several years, particularly in the area of life sciences and biotechnology, activity has picked back up tremendously over the past year.
 
But at the conference, co-organized by the National Council on Entrepreneurial Tech Transfer, the National Institutes of Health, and the National Science Foundation, and co-hosted by the University of California and University of Maryland, Heesen stressed that policy changes in the US, including SBIR’s VC-disqualification rule, continue to threaten the general health of the VC industry [see BTW 10/8/2007]. 
 
Last December, a survey released by the Association of University Technology Managers indicated that the university spinout model — which relies heavily on SBIR and venture capital funding — has lost some steam recently as 553 new startup companies were created in 2006, the most recent year for which figures are available, a 12-percent decline from the 628 spin-offs created in 2005 [see BTW 12/10/2007].
 
Additionally, two months ago, a report by PricewaterhouseCoopers and Heesen’s NVCA found that the life-sciences sector set an all-time record for VC capital investing in 2007 with $9.1 billion invested in 862 deals compared to $7.6 billion shared among 786 deals in 2006 [see BTW 1/23/2008].
 
And, according to the study, life sciences accounted for 31 percent of all VC bets in the US — also an all-time high — making it the top-ranked investment sector last year.
 
There is no concrete cause and effect with the 2003 implementation of the VC-disqualification rule and a reported recent rise in reported VC investments in the life sciences or a recent decline in SBIR grant applications. However, Mark Leahey, executive director of the Medical Devices Manufacturers Association, testified at last week’s Committee on Small Business hearing that since the SBA’s reinterpretation of ownership requirements under SBIR, the number of medical technology companies applying for grants has significantly declined. His complete testimony can be read here.
 
Supporting this, Biotechnology Industry Organization CEO Jim Greenwood testified that SBIR grants generated by the NIH have declined every year since 2005, during which they slid 11.9 percent year over year. In 2006 they fell 14.6 percent, and in 2007 applications declined by 21 percent. His complete testimony can be seen here.
 

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