The Small Business Innovation Research (SBIR) program reserves a portion of federal agency extramural research and development (R&D) funding for small business. The program, having survived for five years on a series of short-term extensions — the Congressional equivalent of life support — was finally re-authorized in late 2011 for a term ending in 2017. In the re-authorization, Congress resolved a multi-year legislative battle concerning the appropriate role of venture capital firms in the SBIR program by directing the U.S. Small Business Administration (SBA) to change its SBIR program rules to foster an increased, but limited, role for venture capital investment in SBIR program participants. The SBA’s proposed rules to implement those changes are to be published by late April 2012. In anticipation of the SBA’s imminent rulemaking, this Alert highlights this new opening for investment in SBIR applicants and participants, and the opportunity for interested parties to comment upon the SBA’s proposed rules.
The SBIR program was created in 1982 by the Small Business Innovation Development Act and recently reauthorized in Division E of the Fiscal Year 2012 National Defense Authorization Act (2012 NDAA), Pub. L. No. 111-84. The program requires that 11 federal agencies annually set aside 2.5 percent of their extramural R&D budgets (approximately $2 billion in total) for small business concerns (SBCs). Although the program is administered by each agency as part of its respective R&D grant program, the agencies operate under rules issued by the SBA, and SBIR program eligibility is determined under SBA rules.
Venture capital investors have long complained that the SBA’s SBIR program eligibility rules inhibit private investment in SBIR participants, and Congress responded to those complaints with Section 5107 of the 2012 NDAA. That section directs the SBA to liberalize its SBIR program eligibility rules to facilitate equity investment in SBIR applicants and participants (SBIR firms) by venture capital firms, private equity firms, and hedge funds (VC entities). On the other hand, Section 5107 limits the SBIR funding pool available for this liberalized treatment to a percentage of agency SBIR funding (25 percent or 15 percent, depending on the agency), effectively creating a pilot program to see how the new eligibility rules actually play out in practice.
Despite the funding cap, the impact of Section 5107 will be quite significant, as it will permit VC entities to invest in SBIR firms at equity levels not heretofore possible without jeopardizing the SBIR firm’s qualification for the SBIR program. These changes should assist SBIR firms in obtaining a VC investment sufficient to get their inventions across the so-called “valley of death” — from the SBIR-funding stage to commercialization — that now plagues the SBIR program due to the difficulty in obtaining VC funding under current SBIR program restrictions. Signaling the urgency that Congress placed on these changes, Section 5107 requires the SBA to publish proposed rules by April 2012, and final rules by December 2012.
In this Alert, we discuss how the existing SBIR eligibility and affiliation rules constrain VC entity investment in SBIR firms. We then describe how those constraints have been eased by the 2012 NDAA changes, and discuss several considerations or unresolved issues that might affect VC entity investment in SBIR firms even under the new SBA rules. We conclude with an explanation of the upcoming opportunity for interested parties to comment on the SBA’s proposed rules.
Limitations on VC Entity Investment Under Existing SBIR Rules
Existing SBA rules limit investment by VC entities in SBIR firms through a combination of the applicable SBA size standard and the SBA’s affiliation rules, plus a restrictive U.S. citizenship requirement applied to SBIR firms. In short, the applicable SBA size limit for SBIR participants is 500 employees, which includes the SBIR firm’s employees plus the employees of all firms with which the SBIR firm is considered affiliated. When a VC entity (or group of VC entities with common shareholders) holds a controlling interest in an SBIR firm, the SBA deems the VC entity (or the VC entity group), as well as the companies in the VC entity’s portfolio of investments, to be affiliated with the SBIR firm. The typical impact of VC entity affiliation with the SBIR firm is to render the SBIR firm, a large firm, ineligible for SBIR grants, because the total employee count of 1) the SBIR firm’s employees, plus 2) the VC entity’s employees (including portfolio companies), will exceed the 500-employee limit, with the result of precluding the VC investment.
Should the VC investment not run afoul of the size standard/affiliation obstacle, the SBA’s interpretation of the statutory U.S. citizenship requirement applicable to SBIR applicants presents a second significant obstacle, by precluding majority ownership in SBIR firms by VC corporate entities. SBIR funds are limited to firms that are considered to be U.S. citizens, which the SBA interprets to mean that 51 percent of the ownership and control of the SBIR firm is held by U.S. citizens who are natural persons. This interpretation effectively excludes U.S. corporate entities from the citizenship determination for an SBIR firm. As most VC investment is provided through corporate entities, not natural persons, the SBA’s natural person, U.S. citizen requirement frequently precludes VC majority control of SBIR firms, as such control through corporate entities will render the SBIR firm a non-U.S. citizen. Thus, even when the total employee count of the SBIR firm plus affiliated VC portfolio companies is below the 500 employee cap, VC corporate control of an SBIR firm is still not an option.
As VC entities are understandably reluctant to invest in R&D-stage entities without having majority control, the impact of the SBA’s rules has been to severely limit the amount of venture capital available to SBIR firms, retarding their ability to move their SBIR-funded inventions from R&D to commercialization. Thus, the VC community has been pushing Congress for years to address these limitations, which resulted in the 2012 NDAA reforms of the SBIR rules. While the reforms are quite limited compared to what the VC community had sought, they represent a critical opening of the SBIR door for VC investment.
2012 NDAA Liberalization of SBIR Ownership/Affiliation Rules
The 2012 NDAA increases the opportunity for VC entity investment in SBIR firms through two changes to the existing SBIR program rules. First, the statute liberalizes the SBA’s affiliation rules with respect to VC entity portfolio companies by providing a limited exclusion from affiliation for those VC entity portfolio companies in which the VC entity holds only a minority, non-controlling interest.
Specifically, the statute provides that, even when a VC entity itself is determined to be affiliated with an SBIR firm, a portfolio company of that VC entity shall not be determined to be affiliated with the SBIR firm when 1) the VC entity is not a majority owner of the SBIR applicant,1 and 2) the VC entity is not a majority owner of the portfolio company and does not control a majority of the board of directors of the portfolio company.
This appears to be a “safe-harbor” provision, meaning that a non-affiliation determination is mandatory when both of those two criteria are met, because, while the statute retains the SBA’s general authority to find that VC entities and their portfolio companies are affiliated with an SBIR firm, that authority is made subject to 1) the foregoing provision, and 2) a related provision precluding a finding of affiliation based solely on there being one or more shared investors in both the SBIR applicant and the portfolio company. Additionally, a non-affiliation determination as to the portfolio companies could still be found even if only the second of the two criteria were met.
Second, the statute directs SBA to revise its SBIR rules to allow SBIR program participation by certain SBCs that are majority-owned by multiple VC entities. This effectively creates an exception to the SBA’s requirement that SBIR firms must be majority-owned by natural persons. Thus, the new citizenship rule will be, in general, that SBIR firms must be at least 51 percent owned by U.S. persons/domestic entities — whether that majority interest is held by natural person U.S. citizens/lawful aliens, U.S. domestic VC entities (none of which owns or controls 50 percent or more of the SBIR firm), or some combination thereof. The statute also directs the SBA to define various aspects of foreign ownership, so the nuances of what will constitute qualifying and disqualifying citizenship status for VC entity ownership interests remains to be determined.
Precisely how all these changes will be accomplished will not be known until the SBA issues amendments to its SBIR rules. The statute mandates that the SBA issue proposed regulations implementing the new approach to VC entity investment by April 29, 2012 (within 120 days of the statute’s enactment), and adopt final rules by December 2012. Also, the statute limits the percentage of an agency’s annual SBIR funding that can be given to SBIR firms that take advantage of the new rules, as discussed below.
Considerations Affecting VC Entity Investment in SBIR Applicants Even Under New Rules
Despite these steps to increase access to SBIR funding by SBIR firms with substantial VC entity investment, there will remain significant SBIR limitations on VC entity investment. A summary of the major remaining impediments or potential obstacles to investment in SBIR applicants by VC entities is provided below.
- No single VC entity can own a majority interest in the SBC applicant
Even under the liberalized rules of the 2012 NDAA, majority ownership must be split among multiple VC entities. In other words, majority ownership of an SBC by a single VC entity will remain a disqualifying feature for participation in the SBIR program.
- Caps on the amount of SBIR funds awarded to applicants majority-owned by multiple VC entities
The 2012 NDAA limits the amount of SBIR funding available to SBIR firms under the new rules. The National Institutes of Health (NIH), the Department of Energy (DOE), and the National Science Foundation (NSF) may award up to 25 percent of their annual SBIR funding to SBIR firms that are majority-owned by multiple VC entities. All other federal agencies may award up to 15 percent of their annual SBIR funding to such applicants. The impact of this provision is to preserve the lion’s share of SBIR funding for all other applicants.
- Written determination by agencies required to justify award of SBIR funding to SBC applicants majority-owned by multiple VC entities
To implement the 25 percent/15 percent funding authority provided by the 2012 NDAA, NIH, DOE, NSF, or another agency desiring to make such grants must first file a written determination with Congress that SBIR awards to such SBIR firms are necessary to induce needed investment by VC entities in small business research, and are consistent with the agency’s SBIR program.
- Registration with SBA required for SBIR firms majority-owned by multiple VC entities
SBIR firms that are majority-owned by multiple VC entities must register with the SBA prior to applying for an SBIR award, thereby providing public notice of their application status.
- “Transparency” requirements may require disclosure of information about VC entities or their investments in SBIR awardees
The SBA is required to maintain a public database providing certain information about SBIR awards. The 2012 NDAA requires that database to include information identifying whether the SBIR awardee has VC entity investment and, if so, whether the SBIR awardee is registered as majority-owned by multiple VC entities.
In addition to the public database regarding SBIR awards, the SBA maintains a non-public government database that is to be used “exclusively for SBIR and STTR program evaluation.” That non-public government database contains more detailed information about the SBIR applicants and awardees than is available in the public database. The 2012 NDAA requires the non-public government database to include detailed information about the extent of VC entity investment in an SBIR awardee, including:
- The amount of VC entity investment in the SBIR awardee as of the date of SBIR award
- The percentage of ownership in the SBIR awardee held by a VC entity
- The names of the owners and the respective ownership percentages of the SBIR awardee, when an owner is a corporate entity and not organized under the laws of a state or the United States (which would obviously cover a non-domestic VC entity)
The statute does not require disclosure, in either the public SBIR database or the non-public government SBIR database, of the identity of domestic VC entities that have an ownership interest in the SBIR awardee, or the amount of ownership interest held by such VC entities. It remains possible, however, that the SBA would require the disclosure of such information — at least in the non-public government database — as a means of substantiating an SBIR applicant’s claimed status as majority-owned by multiple VC entities.
- “Foreign” ownership remains an obstacle to SBIR participation, and several criteria relating to the determination of a VC entity’s “foreign” or “domestic” status remain to be further defined in the forthcoming SBA rule-making
The SBIR rules will continue to preclude participation by majority “foreign-owned” entities. Among the criteria the SBA is directed to consider in determining whether an SBIR applicant meets the domestic ownership requirement is whether the SBIR applicant is at least 51 percent owned or controlled by U.S. citizens or “domestic” VC entities. The 2012 NDAA does not specify how the nationality of VC entities is to be determined, so that issue will be addressed in the SBA regulations implementing the statute. The standard SBA adopts for considering a VC entity “domestic” could impact the eligibility of certain SBCs, if a majority interest in the SBC is determined by SBA to be held by “non-domestic” VC entities or individuals.
The 2012 NDAA also directs SBA to consider whether an SBIR applicant is a “direct or indirect subsidiary of a foreign-owned firm,” and further directs SBA to consider whether the criteria for such a finding should be: 1) ownership of more than 20 percent of the SBIR applicant by a VC entity that is a “direct or indirect subsidiary of a foreign-owned entity”; or 2) ownership, in the aggregate, of more than 49 percent of the SBIR applicant by entities that are “direct or indirect subsidiaries of a foreign-owned entity.”
Again, the parameters of how SBA defines these criteria for “direct or indirect subsidiaries of foreign-owned firms” remain to be developed through the rule-making SBA will conduct to implement the 2012 NDAA. VC entities would be well-advised to review the criteria in SBA’s proposed rules and be prepared to submit comments if those criteria are deemed to be too restrictive of VC entity investment.
Comment Opportunity on the New Eligibility Rules
As explained above, the SBA is required to issue proposed rules implementing Section 5107 by late April. The proposed rules will be published in the Federal Register and the public will have an opportunity to submit comments on the proposal to the SBA, likely for a period of 60 days following publication. The proposed rules will be provided via another Alert.