SBIR interpretation change

I have missed a couple of issues due to SBIR deadline (again) and my daughter's first birthday. I have a pretty interesting topic here that I don't think too many people in the industry are aware of. Recently the SBA is enforcing an interpretation of the SBIR guidelines that limits the ability for venture funded companies to pursue SBIR grants. In my view this ruling limits emerging companies, but allows some fully mature public companies to qualify. Something clearly needs to be done about this, since it is clearly against the "spirit" of the SBIR award process.

A primer on startup funding

For those of you who have not been involved in an early stage company, I thought it would be worthwhile to take a few lines to lay out the normal development cycle of an early stage company. The development cycle for therapeutics requires several years and hundreds of millions of dollars to be taken to completion. While the approval process for diagnostics and medical devices are shorter and less costly, you are likely to spend in the tens of millions for a certified diagnostic product and nearly one hundred million for an approved medical device. There are many different funding strategies for the development of these products.

Typically, early-stage companies will seek venture capital funding early to develop the product to a stage that it will be attractive for a corporate partnership with an established company that can carry it through to commercialization. At this stage in a company life-cycle they rarely have all the pieces to form an attractive company (management team, intellectual property protection, proof of principle, clear path to the clinic). In these types of situations the company will commonly have to give up more than 50% of the outstanding shares of the company in order to obtain the pieces detailed above. Investors view it as a high-risk proposition and especially in the current climate will extract a heavy price from startup companies.

What exactly happened

What exactly happened? Recently an SBIR was denied based on the following statement in the regulations: the SBIR program regulations require that, to be eligible for SBIR grants, companies must be "small" (<500 employees) and "at least 51% owned and controlled by one or more individuals that are United States citizens or permanent resident aliens. This ruling was considered to restrict an SBIR applied for by a subsidiary of a larger company. What happened later is that the SBA used this decision to deny startup companies that contained were funded by venture capital based on the statement of "individuals" as described in the regulations, ruling that venture capital firms were not individuals and furthermore commonly had persons who were not of US citizenship or permanent resident status. As it stands now the 51% applies to corporations, venture capital funds, pension funds and other investment groups. So a company could have one or a group of "individuals" investing many millions and owning 70-80% of a company and still be eligible.

Changes in rules proposed

The SBA has proposed a change in the rules, but it does not address this issue very well. In 68 FR 33412 the SBA requested comments on the proposed rule change that would allow subsidiary companies to apply for SBIRs if the total number of employees was below 500, the parent company was 51% owned by US citizens or permanent residents, and the subsidiary company was 100% owned by the parent. Hardly a solution to the problem indeed...

The ironic thing here is that additional consideration is given to companies which attract outside investment to promote their product! Extra points are given in the phase II application when outside investment is retained to promote the product. Clearly counter to the current interpretation of the regulations.

SBIRs and public companies

I decided to do a quick check of Yahoo! looking at public biotech companies that has recently obtained major SBIR funding and looking at the institutional ownership. Obviously there could have been considerable buying and selling between the statements and the press release, but institutional holdings of companies with high profile SBIRs were between 40% and 80%! Remember if foreign investors, other companies, or other institutional investors hold more than 49% of outstanding shares you are not eligible (this means a lot of struggling early-stage companies will not be getting their $100,000 phase I grants).

In closing I think this is a major problem when public companies can obtain SBIR funding and small struggling companies cannot. I will follow this and let everyone know when or if this is resolved.

Links for more information:

NIH statement on Small Business Eligibility Requirements for Applicants to the SBIR and STTR Programs: http://grants1.nih.gov/grants/guide/notice-files/NOT-OD-03-053.html

National Venture Capital Association letter to Gary Jackson of the SBA: http://www.nvca.org/med_industry_80403.html

theLabRat