Recent legislative developments, which are still ongoing, suggest that some of the long standing legal and regulatory principles affecting private equity and venture capital investment in small government contractors may be undergoing a change. We have written on small business, private equity and venture capital affiliation before and wanted to bring these developments to your attention.
For years, venture capital firms have sought access to companies participating in the Small Business Innovation Research (“SBIR”) program. These efforts have been stalled by Small Business Administration (“SBA”) determinations that venture capital companies are “affiliated” with their portfolio companies, and therefore exceed the SBIR size standard. Recent legislation passed by the House of Representatives and Senate may, however, allow for greater venture capital participation in SBIR. Conference negotiations are ongoing. These reforms may also have implications for the treatment of venture capital affiliation for other small business programs.
The SBIR program, although not particularly wellknown outside of the Beltway, is a natural place for venture capital activity. Through agency-specific grants, the program has been responsible for over $17 billion in awards to small businesses engaged in high technology industries.1 By any measure, SBIR has been remarkably successful, with responsibility for the issuance of over 45,000 patents.2
Technological innovations such as precision lasers used for eye surgery, improvements in contact lenses and a breath test for lung cancer, breast cancer and pulmonary tuberculosis all have been developed as a result of the SBIR program.
This success has been achieved largely without significant venture capital funding. This is the case because, in order to be eligible for SBIR funding, a small business concern must (1) be 51 percent owned by natural persons and (2) including its affiliates, have a number of employees not exceeding 500.3 Many venture capital companies that have attempted to access the program have failed both of these tests.4
While prospective SBIR small businesses with venture capital investment likely employ fewer than 500 individuals, these business are often deemed to be large – and ineligible for the SBIR program – because of affiliation. Affiliation, a concept that allows SBA to aggregate the employees and revenues of related concerns, can result in a finding that an SBIR candidate is not only affiliated with an investor private equity firm but also with other portfolio companies that the private equity firm invests in. As a result, a firm of 50 employees could, for size standard purposes, be deemed to have hundreds of employees.5
Affiliation can be found for a series of reasons. Businesses can be determined to be affiliated based on control, ownership, management, and/ or contractual relationships.6 Notably, even venture capital companies that do not control a majority of the Board of Directors or own the majority of the shares of a small business can be found to be affiliated with that business. For example, so-called “negative control” over a business can be found when the venture capital company, “though lacking affirmative ability to approve actions . . . can block corporate action by the other concern.”7 This restriction would include many negative covenants that are standard in venture capital arrangements.
In order to reduce affiliation concerns for venture capital companies that want to invest in SBIR companies, the House and Senate have adopted slightly different strategies. The House has taken the most aggressive position, eliminating affiliation altogether unless a single venture capital company8 owns half of the SBIR company: “the Administrator shall not consider a business concern to be affiliated” with its venture capital parent, or any of that parent’s portfolio companies, if that company does not own 50 percent or more of the concern or control the majority of the board of directors of the concern.9 The Senate bill takes a more conservative approach, requiring the Administrator to “establish requirements relating to the affiliation by small business concerns with venture capital companies, which may not exclude a United States small business concern from participating in the program . . . on the basis that the small business concern is owned in majority part, or controlled by, more than 1 United States venture capital company, so long as no single venture capital company owns more than 49 percent of the small business concern.”10 The Senate bill, however, does limit awards to companies that are majority controlled by venture capital companies to 18 percent of National Institutes of Health awards and 8 percent of each other agency’s total awards during the first fiscal year.
A few aspects of these proposals are of note. Under this legislation, an SBIR participant can be 100 percent owned by venture capital companies, as long as no one company controls more than 49 percent. In addition, it appears from the current language of the legislation that a venture capital company seeking to invest in an SBIR company would only have affiliation concerns based on stock ownership and seats on the Board of Directors. While the legislation does not closely track the statute, it appears that, under the House bill, negative covenants, even those that would block typical day to day activities of the company, are presumptively acceptable and do not create affiliation concerns.
While we will continue to follow this legislation through conference, this early stage of the reform effort raises real questions about the future application of affiliation restrictions to some venture capital companies. Specifically, if the lack of readily available capital has convinced Congress that affiliation rules should not apply in full force to venture capital companies for one small business set aside program, other exemptions to affiliation may follow.