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Saturday, July 12, 2008

Who deserves SBIR funding?

The Wall Street Journal reported this week on an ongoing controversy over eligibility for SBIR funding. This follows up on earlier reporting by the Washington Business Journal.

The Small Business Innovation Research program (established 1982) provides grants of about $200K for Phase I and $1.5 million for Phase II from 12 cabinet departments and agencies. In addition, five of these agencies administer SBTTR (Small Business Technology Transfer) grants — which are similar to an SBIR except they require cooperation with a university or federal research lab. The grants are funded by a Congressional mandated set aside of 2.5% of their research budgets.

An entire industry has developed around SBIR. At the university-industry conference last week at UCI, it is clear that states see integrating with SBIR is one of the easiest and most effective parts of a regional innovation strategy, as with the presentation by Lee Herron of the Georgia Regional Alliance. Drafting off the SBIR screening and legitimation, states can provide matching funds or bridge funds for firms that have won a first SBIR and are awaiting receipt of follow-on funds

The SBIR was created by PL 97-219:
The Congress finds that
  1. technological innovation creates jobs, increases productivity, competition, and economic growth, and is a valuable counterforce to inflation and the United States balance-of-payments deficit;
  2. while small business is the principal source of significant innovations in the Nation, the vast majority of federally funded research and development is conducted by large businesses, universities, and Government laboratories; and
  3. small businesses are among the most cost-effective performers of research and development and are particularly capable of developing research and development results into new products.
Therefore, the purposes of the Act are
  1. to stimulate technological innovation;
  2. to use small business to meet Federal research and devel- opment needs;
  3. to foster and encourage participation by minority and disadvantaged persons in technological innovation; and
  4. to increase private sector commercialization innovations derived from Federal research and development.
The SBIR program is the envy of the world — other countries want to copy “the world’s largest seed capital fund.”

Today, however, there is a controversy about SBIR eligibility. In particular, the question is whether VC funded firms are eligible for SBIR funding. The rules were tightened in 2004 after the GAO investigated on behalf of Congress.

Of course, VC funded firms don’t care for this rule. The biotech industry trade association has been lobbying since 2003 to get the rule repealed, because very few biotech firms get started without VC. Their opposition has been far less organized, with people like SBIR consultant Gene Watson of Wyoming  and some bloggers fighting to keep the restrictions.

There are arguments on both sides.

The VCs and their supporters say that the ideas that have already attracted outside capital are better quality ideas than the average submission and thus should be included. Of course, the biotech industry also cite the importance of innovation in their industry to human health and well-being.

While that’s true, there are several possible arguments in favor of the restrictions.

First, the restriction does not prevent VC-funded firms, only those that are 49+% owned by firms or investment funds. If the VCs don’t dilute their entrepreneurs, then biotechs can get funded. Or biotechs can get funded early in their life before heavy dilution. This would be consistent with the use of an SBIR as a seed capital fund.

Second, the SBIR funding is relatively small compared to the VC funding; a quick check suggested the average 2005 Series A was $21 million but today is more like $30 million. So reducing SBIR funding by $500K will just force the VCs to pony up another 1.5%, perhaps diluting the founders another 3% or so. Relaxing the restriction would reduce the amount of money VCs have to put into biotechs — but (economists would predict) not allow biotechs to develop any drugs they would otherwise be unavailable to do.

This leads to the final point. The point of the SBIR would appear to be to make sure that small businesses that don’t have money to fund their innovations have a way to do so. The VC-backed firms have shown they can raise money, so the question is just who’s going to put up the money to fund their innovations — the government or the VCs.

This year, the biotechs are winning handily. A change to explicitly allow VC-funded firms to get SBIR grants is incorporated in the SBIR reauthorization bill H.R. 5819, which has passed the House 368-43 and is heading to the Senate. A quick glance at the votes suggests that won support of all Democrats and all but a few Republicans (not clear if their opposition is from the small business-friendly “Main Street” wing or from the anti-spending Libertarian wing).

Given the SBIR program expires Sept. 30, there will be pressure to pass some sort of reauthorization bill. Given the lopsided House vote, it seems unlikely the Senate will reinstate the restriction. It appears that the WSJ story was prompted by efforts to publicize the fight by the National Small Business Association, but for the average citizen or politician, this would appear to be an esoteric policy fight.