Wednesday, April 1, 2009

Would VC Control Stifle the Innovation in SBIR?

The SBIR advocacy is mobilized. Dozens of small business owners are now focused on raising the level of awareness of the importance of SBIR to our legislators in the House of Representatives. Our immediate focus is ensuring that there will be a full SBIR reauthorization debate this time around, and that we will be included in it. (See for details.)

Central to the debate is whether VC controlled small businesses should be eligible to compete for SBIR awards. Some say it's a good idea, others say it's not. Both sides have compelling arguments. Both sides claim that their position will ensure SBIR Program "success". But, what is that?

The problem is that we've never really settled on what is SBIR success. Is it how many tough problems got solved? Is it how many small businesses got started with SBIR as seed funding? Is it how many high-paying jobs got created? Is it maximizing ROI for the funding agency? Is it how many patents get filed? Is it how much revenue is generated by the awardees in commercialization? Is it how many SBIR funded companies get acquired or go public? Is it all of the above or none of the above? The fact is that no one has ever come up with a universally accepted answer to this. I've seen every one of the above cited as the critical success factor. SBIR success is in the eyes of the beholder.

I'm going to use my Blog as a forum for exploring this, as the better we understand all of these perspectives, the better we'll be able to provide persuasive opinion to our legislators, and, hopefully, guide the improvement of SBIR.

Our first guest columnist is Jonathan Pearl. The subject is innovation, and whether a VC controlled company still cares about that...


The difference between a VC and a small business: why SBIR is not the venue for supporting Venture Capitalists, by Jonathan Pearl

In a letter dated March 11, 2009, on the FY 2010 proposed budget, House Small Business Committee Chairwoman Representative Nydia Velazquez argues that: "The SBA should permit venture capital-backed small businesses to be able to fully participate in the Small Business Innovation Research program."

I laud Representative Velazquez her energy and commitment to supporting innovation and its benefits for the nation's economy, but I question the specifics of her case. By the rules of the SBA regarding the definition of a small business, nothing prevents venture capital-backed companies from fully participating in SBIR. The rules however require that small businesses be majority-owned by individuals, meaning simply that venture-capital groups can not own a majority stake in a small business eligible to compete for SBIR funding.

Venture capital firms typically have far greater resources than small businesses, providing an unfair advantage because those resources can be expended in the proposal stage. Many truly small firms may find the time and money needed to compete in such a field prohibitive, regardless of the worthiness of their proposed efforts. The unfortunate consequence of permitting firms majority-owned by VCs to compete against startups may be to stifle the innovation SBIR seeks to promote.

Representative Velazquez continues: "Such participation is essential for high-growth small firms seeking capital, particularly during this period of economic weakness."

The argument appears to be that the capital needed by high-growth small firms can only be provided by venture capital groups taking a majority-stake in their businesses. To be sure, venture capital serves a useful function in society. Venture groups can provide an influx of capital for high-growth ventures. Their motivation however is financial gain, not necessarily innovation. They seek a high return for their investments. There is nothing wrong with the profit motive, it simply should not be subsidized by public coffers. Allowing VC majority-owned firms to tap into SBIR resources is akin to providing TARP funds to remodel executive offices. It's the wrong course.

Entrepreneurship and small business innovation are critical for our economy and inestimably beneficial to society. Researcher entrepreneurs are most often motivated by a passion, driven by their ideas to solve problems in innovative ways. Their incentive is both innovation for its own sake and the financial gains that accrue from filling an unserved need. This juxtaposition of overlapping motives keeps innovation at the forefront. SBIR allows federal agencies to define their own high-priority needs.

It has been suggested that some agency administrators are concerned over difficulty identifying enough high-quality proposals to support even current levels of SBIR allocations. It is odd that Representative Velazquez would argue that many SBIR-awarded small firms need a greater influx of capital while agency administrators are concerned over not being able to spend all of their SBIR funding.

I would think the solution to both concerns can be managed without expanding SBA rules that define small businesses to include majority ownership by venture capital groups, or excluding small businesses from the efforts to stimulate economic activity:

1. Maintain SBA rules that require majority-ownership by individuals.

2. Permit agencies some discretion to provide additional capital where needed. Capital-intensive programs like some at NIH could be enhanced by permitting the sponsoring agency to spend some of their SBIR funding for providing necessary facilities or materials to SBIR-awardees, without overinflating the individual awards. Alternatively, the agencies could be allowed some discretion in providing additional amounts (in excess of the base award) for materials and facilities that may be necessary for successful execution of the project. Oversight would be key in this case, to ensure that SBIR expenditures are maintained to support SBIR efforts, for instance that residual materials or equipment be retained for future use by SBIR projects.

3. Further, if there is concern that the costs associated with administering a large number of small awards is unfunded, a reasonable percentage of the SBIR Base Allocation can be specifically earmarked for this purpose, allaying agencies' resistance to potential increases to the percentages for SBIR Base Allocations.

Finally, I wish to argue that America is not at a lack for innovative ideas. If agencies are failing to receive a sufficient quantity of worthy proposals, the solution must lie in publicizing the availability of these programs where they will most garner an appropriate response.

This nation has a shamefully high number of unemployed and underemployed PhDs from across the spectrum of fields, who could provide the innovation we so desperately need to rise above our current crises. We have done an abysmal job of employing these valuable individuals in our institutions of higher learning. There are too few positions available for would-be professors, leaving thousands without an outlet for their creativity. Why not tap this resource? Improving and expanding SBIR, without losing its focus on innovation, is the first step.

Jonathan G. Secora Pearl, PhD, President
Perceptral LLC; Racine, Wisconsin

Comments anyone?

If you'd like to have your opinion included here, send me a well constructed essay (please try to keep it below 750 words) and I'll consider posting it.

[In one of our advocacy conference calls a gentleman from Boston spoke quite eloquently about why eligibility of VC controled companies would be a good idea. I didn't get his name. If you know who that was, please have him contact me.]


- Fred Patterson - said...

Here's some anecdotal support for your premise, Jonathan. When one of my companies closed our Series A round, we still had a few Phase II contracts with DOD to complete. We had two primary VC investors with Board seats, one from Wall Street (A) and one from Silicon Valley (B). Investor A wanted to know if we could "get out of the DOD contracts early", as we were "not in the innovation business any more" and needed to totally focus on getting our prototypes configured for manufacturing and develop our distribution channels. Investor B was, fortunately, not of a similar mind, and we convinced A to drop that idea, not that we could have done it anyhow. The company did continue to propose SBIRs, but we were VERY selective (and strategic)on what we went after.

Louis B said...

I find it somewhat laughable for the NIH and NSF to contend that "not enough fundable SBIR proposals" are being submitted. They are probably coming to this conclusion based on the scores from peer review. But, as I have been pointing out to NIH leadership for several years, the peer review process has a major flaw in the selection of reviewers. Inspection of the Conflict of Interest Policy for reviewers specifically excludes "buddies" (i.e. former employers, graduate advisors, or subordinates) from reviewing each others grants, but DOES NOT EXCLUDE COMPETITORS from reviewing their "enemies" proposals. Thus, I've had SBIR proposals rejected for irrelevant but reasonable-sounding reasons: "resources don't include an STM" (which was not needed for the project), or for not having published anything since my second post-doc. This despite very high enthusiasm for the projects' goals, the assembled teams, and the innovation.

The sad truth is that these government agencies have little enthusiasm for the SBIR/STTR programs in general, preferring to fund their academic colleagues. If VC-majority owned companies are allowed into the SBIR program, expect to see most of the grants go to those companies (where the technology comes from an already-well funded professor who does not join the company full time). The rich get richer!

Jonathan Pearl said...

Louis B.,

To support your contention, P. Sherill Neff, in testimony before the House Small Business Committee on March 26, 2009, on behalf of National Venture Capital Association, went out of his way to laud university and government labs, as if following a particular special interest's playbook:

"We often find these innovators in university and government labs..."

"We most often find these opportunities in university and government labs, where scientists have successfully accessed Federal funding to advance their work."

There seems to be a disconnect about the fact that many of the small businesses competing for SBIRs are headed by PhDs with just as worthy qualifications but far less resources than those employed full-time in university and government labs.

Carl Nelson said...

The VC nose-under-the-tent argument seems a waste of energy, and it brings up one major problem with SBIR – that Congress never made SBIR’s purpose clear beyond something for everybody. It gave the agencies full autonomy to pick winners without any criteria, economic nor technological, for program success. It supposed that rule-based management would suffice, because writing real criteria and evaluating programs against them is too hard for politicians. After all, the argument made for SBIR was a fair-share argument that since private industry gave a larger percentage of money to small business than government did, government should give more. The SBIR advocates didn’t propose any program evaluation criteria and Congress enacted merely social objectives. Alas, it also gave the agencies an out by letting them shunt small business proposers from mainline programs into SBIR.

Since most of the money goes to mission agencies which don’t care about VC involvement, and don’t care about the economic or market potential either, the amount of SBIR money that would go to VC-heavy firms would be small. And conversely, VCs are not interested in technologies that only a government could love, nor are they likely to be thrilled with a large government nose in their business. The result is that tons of SBIR money has gone into firms that offer incremental advances in technical knowledge over and over and over. If Congress cared about economic success, it would write rules that match the economic objective.

Indeed, the present rules, with or without VC majority ownership, are actually loose enough to allow any agency to get economic success in addition to technological benefits. I did it for five full years after I saw five years of government-only investment going nowhere. I didn’t have to specify any form of co-investment, I had only to use competitive criteria on future market potential, and I allowed almost any kind of economic co-investment that showed that serious money cared about the results. The market-oriented companies filled my in-box with co-investment prospects. The companies doing incremental R&D could not compete with the market-driven companies. For the ones who had the potential but not yet the partner, I gave them some money for Phase II with a requirement that anything beyond that had to be matched in some ratio that I decided was appropriate for the technology’s maturity. The government money went only to the technical development work, since it was appropriated only for R&D, and the matching private money could do anything that would advance the technology toward a profitable market of some sort. In most cases, it was NOT VC money, mostly I presume because the technology was still pretty young.

Oddly, I never saw any other SBIR program of the time (early 1990s) trying anything like that approach. The mission agencies apparently would rather pay the entire development of a technology and own it than invite private money to help develop the technology into usable form at no cost to the agency and long before the agency would ever finish development itself. Agencies live in the competitive world of agency budgeting and continuously shifting priorities.

Let the VCs in; they will never get much of the money and they will get more technologies to market than the government will if left to its own devices. The real success step is to ignore the VC issue and concoct a program that cares about economic success.