Small Business Administration officials are touring the country to solicit public comment on the so-called 51% rule, which precludes institutionally controlled companies from receiving federal Small Business Innovation (SBIR) grants.
“This is the best chance for venture capitalists and VC-backed companies to band together in opposition to this rule, because it really could end up going either way,” says an SBIR program manager who declined to be named. “Those in favor of keeping the 51% rule are definitely showing up.” The 11-stop caravan began in Seattle on June 2 and will conclude in Los Angeles on June 29.
A company must be majority-owned (51%-plus) by so-called “individuals,” so as to avoid big drug or defense companies from setting up small subsidiaries to receive SBIR funding.
Supporters of the restriction say that companies with deep-pocketed owners don’t need extra funding on the federal dime, but VCs insist that SBIR grants help finance high-risk, off-platform innovation that VCs themselves are unwilling to back.
Historically, VC-controlled companies have been considered eligible, since the firms were viewed as partnerships comprised of individuals.
In January 2001, however, an Administrative Law Judge ruled that an SBIR award applicant named CBR Laboratories Inc. was owned by a non-individual entity. The ruling didn’t seem to have much effect until 2003, when it was applied to another SBIR award applicant named Congentix Inc., which was controlled by such VC firms as A.M. Pappas & Associates and MDS Health Ventures. From that point on, VC-controlled companies have been officially banned from receiving SBIR grants.
“The regulation speaks for itself,” says Edsel Brown, associate administrator for the Small Business Administration’s Office of Technology. “Each of the 11 SBIR agencies is a little different, but the SBIR policy directive is supposed to provide uniformity.”
In reality, however, no such uniformity exists. Both the CBR and Congentix cases involved the National Institutes of Health (NIH), so that agency has been steadfast in not awarding grants to companies on the wrong side of the 51% rule (as evidenced by a review of 2005 NIH SBIR awards with data supplied by Thomson Venture Economics, publisher of PE Week).
Most other agencies, however, have ignored the restriction, or at least continue to interpret VC partnerships as “individuals,” rather than as the collection of institutions that actually fund VC firms. This has been of particular import to several VC-controlled companies in the defense market, since SBIR grant approval often results in an automatic bypass of DOD procurement protocol.
Most VC-backed life sciences companies, however, remain unable to access SBIR grants while the current 51% rule is in place.
“I’m coming at this from a right-wing perspective, but, were I in charge, I’d remove the 51% rule and … increase the overall amount of SBIR funding available,” says Jack Biddle, co-founder and general partner of Bethesda, Md.-based Novak Biddle Venture Partners. “It seems to me that companies unable to get VC funding are precisely the companies that the government shouldn’t want to back.”
Biddle endorses a complete removal of the SBIR “individual” language, as does the National Venture Capital Association. Some other VCs, however, feel that there perhaps should be some form of means-testing.
Rodney Ferguson, co-head of health care investing for JPMorgan Partners, says that one solution could be to make VC-backed companies ineligible if they’ve raised more than $40 million or $50 million.
Arthur Klausner, a venture partner with A.M. Pappas & Associates, suggests that a better metric might be cash on hand at the time of SBIR application.
But Brown of the SBA believes that any change will likely be all or nothing. He notes that several middle-ground proposals have come up over the past two years without gaining much traction. He adds that his organization probably won’t act before early next year, although a congressional act could take it out of the SBA’s hands.
Certain politicians had discussed raising the issue last year (based, in part, on an earlier SBA comment period), but ultimately took no action.