How a small investment in an SBIR company can pay BIG returns.
Dr. Kurtz recently delivered a very well received presentation to the investment community in Newport Beach, CA. He first provided background information on the Small Business Innovative Research contract process, and then described how a partnership between a smart investment company and a smart SBIR company has the potential to generate a 35% – 45% rate of return in a relatively short period of time. In this entertaining and informative presentation, he lays out the activities and steps that must take place over a five-year time frame to turn an innovative technology into a successful commercial enterprise. Click here to see if BIG returns could be in your future!
SBIR Background, Recent History, and Future Outlook
SBIR—Small Business Innovation Research—is a federal government setaside for small businesses. Specifically, each federal agency with a research budget exceeding $100 million annually must allocate at least 2.5% to SBIR. Some products that have grown out of SBIR projects include the videoconferencing system used by the U.S. government, a lightweight spectrometer used by NASA on Mars and by cosmetics companies in the U.S., and the Sonicare electric toothbrush.
History
SBIR was initiated at the National Science Foundation in 1977. It spread to all federal research agencies in 1982 and is governed by the “SBIR Law,” 15USC638. There are two purposes to this program: (1) to help small businesses, which are at a significant competitive disadvantage in government contract competition; and (2) to support extremely innovative ideas that have direct application to problems being faced by the federal agency. The ideas to be funded were to be so innovative that they could not attract venture capital.
SBIR, then, is a U.S. federal research program for innovative projects to be developed by small businesses. A “small business” is defined by the Small Business Administration (SBA) and generally means a business with no more than 500 employees. Since SBIR is a program designed to fund solutions to agencies of the U.S. government, recipients may be restricted under the International Trade in Arms Regulations (ITAR). The SBA, then defines a company as eligible for SBIR contracts and grants if it meets the following restrictions:
- The business must be owned and controlled at least 51% by individuals who are either U.S. Citizens or Permanent Residents of the U.S. This includes all affiliates, trustees, and stockholders. (It is possible, for example, for one SBIR-eligible company to own another, but not if there are too many foreign investors.)
- The business must have no more than 500 employees, including all affiliates, trustees, and stockholders.
These requirements are self-certified when the proposal is submitted, and must be met as of the date a contract or grant is awarded.
Participating Agencies
As of October 1, 2010, the following 11 agencies (with subagencies) participate in SBIR:
- Department of Agriculture
- Department of Commerce
- National Institute of Standards and Technology, NIST
- National Oceanic and Atmospheric Agency, NOAA
- Department of Defense, DOD
- U.S. Army
- U.S. Navy (includes U.S. Marine Corps)
- U.S. Air Force
- Chemical and Biological Defense Program, CBD
- Defense Logistics Agency, DLA
- Defense Advanced Research Projects Agency, DARPA
- Defense Microelectronics Activity, DMEA
- Defense Threat Reduction Agency, DTRA
- Missile Defense Agency, MDA
- Office of the Secretary of Defense, OSD
- U.S. Special Operations Command, SOCOM
- Department of Education
- Department of Energy, DOE
- Department of Health and Human Services
- National Institutes of Health, NIH
- Food and Drug Administration, FDA
- Centers for Disease Control (CDC)
- Department of Homeland Security, DHS
- Department of Transportation, DOT
- Environmental Protection Agency, EPA
- National Aeronautics and Space Administration, NASA
- National Science Foundation, NSF
The combined amount spent annually comes to about $2.5 billion. Nearly half of that comes from the DOD and around 25% from NIH. This is currently about 150% the amount invested in startup companies by venture capitalists. A little over half of the funding is issued in the form of contracts (from DOD, NASA, DHS, DOT, EPA, NIST, and NOAA), with the rest coming as grants.
Contracts and Grants
The contracts and grants are divided into three “Phases,” of which only the first two are funded by the SBIR law. Phase I is a proof of concept or proof of principle project, which can receive up to $150,000 over six to twelve months (generally set up either as, for example, $80,000 for six months with a $70,000 six-month optional follow-on or $150,000 for a nine-month project). This helps determine whether or not the innovative concept is likely to ever be turned into a genuine, competitive product – which is the end goal of the three-phase system.
Phase II is the real development project. It lasts up to two years and can be funded up to $1,000,000. At the end of Phase II, the project should have a prototype ready for commercialization (being turned into a product) and, perhaps, a commercialization and business plan to exploit the product.
Phase III is a production contract from the government. It’s still considered SBIR, but it gets no funding from the SBIR program of the agencies.
You can see that there is a large leap from Phase II to Phase III – from the laboratory or engineering prototype to the production level. The SBIR concept was that this would be funded by venture capital or similar investment.
Recent History
During the early 2000s, some organizations (and some Representatives) thought that the definition of an SBIR-eligible company should be changed. They wanted to change the requirement of being owned by U.S. Citizens or Permanent Residents to include corporations. That was rejected, since it could lead to a situation in which a federal contractor could: (a) discover a problem in its production for the government, (b) ask the government for an SBIR project to address this problem, and (c) create a subsidiary “small business” to get that SBIR award. Since the “small business” had so much inside information, they would be almost guaranteed to win the contract. This would clearly be unfair, so it was not passed.
Another business problem in the early 2000s was the failure of the 1990s venture capital model. Many investment and venture companies lost a lot of money during this period. Some Representatives looked at the SBIR program, and decided it was unfair that a company that is 49% owned by a venture firm (which usually consists of many more than 500 people) is eligible for SBIR, but one that is completely controlled by the venture firm (with over 51% ownership) is not eligible.
This led to an ongoing debate in SBIR circles. There are two reasons for this. First, the venture firms by their natures are less innovative than small businesses still run by their owners. This is why the venture firms are not investing in the technology in the first place, and leads to venture-controlled small businesses developing significantly less innovation in the projects they want to work on. Second, the venture firms need significantly more profit than is typical of an SBIR project. Thus, they want to bypass Phase I and go directly to Phase II – and, often, to get a “jumbo” Phase II project worth up to $5,000,000 over two years. Some of these have been tried, and resulted in funding conversion of a Phase II prototype to a commercialized product that can be the basis of a Phase III contract. This is where the venture funding was supposed to come in, but the venture companies are being funded by the government instead of by their investors.
Note also that the existence of venture funding does not eliminate the small business from receiving SBIR contracts or grants! The law only restricts firms that are controlled by the investment firm—whether through over 50% ownership, common among firms with venture investment, or through having enough outside stockholders and officers that the investment firm makes the day-to-day decisions for the small business—from receiving this funding.
By bypassing Phase I, the venture-controlled firms would either be building on known technology (eliminating the innovative part of the Small Business Innovation Research project) or eliminating the proof of concept (making the funding less likely to succeed). A strong argument against allowing venture-controlled firms to compete for SBIR contracts was made by Roland Tibbets, who was Director of NSF during the initial SBIR program, during the debate on reauthorizing the program on September 30, 2008.
Notice that last sentence. The SBIR law expired in 2008, two years ago yesterday as I write this, and has not been reauthorized. Instead, there has been a series of continuing resolutions, keeping the program exactly the way it is currently. The most recent one expires on January 31, 2011. The main sticking point appears to be the participation of venture-owned small businesses.
I’m going to speculate here. One indisputable fact of the SBIR debate are that there is a small group in the House that are demanding access to SBIR for all venture-owned firms. Another is that they have been using extremely deceptive methods to try to get their way. So I speculate the following.
It is clear that an investment bank will be able to make significantly large campaign donations to a politician than will a genuine small business. Very few SBIR companies make profits exceding $1,000,000/year, and a lot of that goes to business expenses that are not allowed to be charged to the contract. The large investment banks make huge campaign donations, and even mid-sized to small venture investment firms often manage to donate more than $1,000,000 to political coffers. Thus, if a Representative is looking for campaign contributions, he or she would be more likely to get a good contribution from a venture firm than from a small business. This speculation is supported by the changes the small group wants to make in reauthorization, reducing its period from eight years (or 14, as has been suggested by the Senate) to two years – so the reauthorization comes up every time the Representatives are reelected. “Keep getting the SBIR funding – vote for me!”
Interestingly, the Senate—led in this case by the richest Senator, John Kerry of Massachusetts—wants to keep the SBIR program following its two original purposes. I hope that they will succeed. The recent election has moved the most problematic people off the House Small Business Committee, but we don’t know how good their Republican Replacements will be — or even who they will be.
The government is also creating a new program to help companies move from the end of Phase II to the beginning of Phase III; plus, there are several programs in which the government will match external (venture) funding in this area, effectively giving the investing firm an immediate 100% return on their investment. In my opinion, based on the number of useful inventions that come out of SBIR every year, this has been one of the most valuable government programs in history. If it works so well, why try to destroy it?
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