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SBIR and the Phase III Challenge of Commercialization: Report of a Symposium II PROCEEDINGS

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SBIR and the Phase III Challenge of Commercialization: Report of a Symposium Opening Remarks Charles W. Wessner National Research Council Dr. Wessner welcomed participants to the National Academies and set the stage for a discussion of the Small Business Innovation Research (SBIR) program, by noting that small companies are increasingly recognized as drivers of the nation’s high-technology innovation potential and economic growth. Specifically, he noted that: New technologies and innovations generated by small companies are a source of new markets and high-growth industries; Large returns to national economic capability can result from relatively small national investments in transitioning these new technologies to the market (a reality understood by economic competitors); and that With appropriate policy support, promising innovations can become commercial products that drive growth. The nation, he said, faces the overarching policy challenge of developing better incentives to convert often substantial investments in research into innovative, new technologies and then to welfare-enhancing products. Addressing the small businessmen in the audience, he emphasized that they are one of the most important sources of vibrancy and growth for the U.S. economy. In an era of globalization, he said, enhancing the ability of small business to develop and commercialize new products would be a key element of future U.S. competitiveness. One of the strengths of small firms is their flexibility—their ability to quickly shift gears if an initial idea stalls and move into something the market wants. He added that one source of strength in the U.S. economy

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SBIR and the Phase III Challenge of Commercialization: Report of a Symposium derives from the healthy functioning of both large and small companies and the synergies they develop. The Complex Process of Innovation He referred to the “global myth of the linear model” that sees innovation as a one-way process flowing from basic research to applied research to development to commercialization. This model, he said, leaves out the “messy reality” of innovation and many of the surprises that lead to technological breakthroughs. In reality, innovation is a highly complex, nonlinear process that includes major overlaps between various stages of research and development, feedback loops, unexpected outcomes, and unanticipated applications. In addition, other common myths can obscure the transition of research into socially useful products and processes. One prevalent myth assumes that markets operate under conditions of near-perfect information. In reality, market participants have less-than-perfect knowledge, especially about the ultimate value of new ideas. It is often only the entrepreneur who recognizes the potential of his or her idea.1 Economists call this phenomenon “asymmetric information,” which can cause small firms difficulty in obtaining the funding necessary to develop new approaches for the marketplace. Obtaining the funding necessary for commercial development of new technology is not inevitable because of these gaps in infrastructure and the uncertainties associated with new ideas. Markets are powerful and often efficient over time, but they need information to operate effectively. SBIR awards contribute information that helps overcome market asymmetries. Crossing the “Valley of Death” A related myth is that small firms with good ideas will naturally attract the venture capital they need to commercialize their products. In reality, idea-based small firms must cross an early-stage funding gap (or developmental “valley of death”) to make the transition from prototype or early product to commercial success. Many people assume that because U.S. venture capital markets are broad and deep, there is no need or role for government in this process. In reality, venture capitalists themselves acknowledge that they have limited information about 1 For a review of the literature on the information gaps between entrepreneurs and investors, see Joshua Lerner, “Evaluating the Small Business Innovation Research Program: A Literature Review,” in National Research Council, The Small Business Innovation Research Program: An Assessment of the Department of Defense Fast Track Initiative, Charles W. Wessner, ed., Washington, D.C.: National Academy Press, 2000.

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SBIR and the Phase III Challenge of Commercialization: Report of a Symposium FIGURE 1 Breakdown of U.S. venture capital by stage of development, 2004. SOURCE: PriceWaterhouseCoopers/Venture Economics/National Venture Capital Association Money Tree Survey, 2005. new firms and tend to “follow the herd” in picking trends and products. Also, the internal dynamics of venture funds means that they focus on the latter stages of technology development. Consequently, the mainstream U.S. venture capital market tends not to focus on risky, early-stage firms, normally preferring to wait until a firm’s growth prospects are well advanced before committing capital. A breakdown of U.S. venture capital by stage of development (2004) shows that of $20.9 billion invested, only $346 million (1.65 percent) went to start-up or seed investments.2 (See Figure 1.) Another way of describing the funding gap encountered by small firms is to trace the path from concept to development to commercialization. At the initial single-idea level, a firm founder might begin to develop an idea for perhaps a few thousand dollars. The second step might require from $10,000 to 250,000, which is often provided by what some refer to as “friends, family, and fools.” The third step in the funding ladder, requiring funds in the order of $250,000 to 500,000, may be supported by angel investors. Following this is a “missing step” where development investments in the order of $500,000 to $2 million is often required. Such investments are typically too small to interest venture capital investors but too large for most individual investors. Partial government funding of this gap in the form of competitive awards for early-stage technology development can help innovative ideas reach the market, augmenting the nation’s competitiveness and security. After this stage, funding can be provided by early-stage venture capital investments ($2 to 10 million), expansion venture capital funding ($10 to 20 million), and the public equity markets. 2 PriceWaterhouseCoopers/Venture Economics/National Venture Capital Association Money Tree Survey, 2005.

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SBIR and the Phase III Challenge of Commercialization: Report of a Symposium Examination of recent venture capital behavior reveals considerable turbulence, especially over the past decade, when total investments rose from less than $10 billion in 1995 to more than $100 billion in 2000. By 2004 investments had returned to about $20 billion. During that 2000-2004 period, while the United States experienced a five-fold decrease in available venture funding, SBIR and its sister program, the Advanced Technology Program (ATP), were in place to help address this missing step. Focus of the Conference The day’s conference focused on Phase III SBIR activities representing product commercialization, particularly in support of the missions of the Defense Department and NASA. Specifically, the conference would: hear the views of small businesses, prime contractors, SBIR program officers, and government customers, discuss features of the program that have worked during transitions from one SBIR phase to the next, and identify and review features that need improvement. He noted that the conference represented the first time the principal participants in the SBIR program—program managers, representatives of leading prime contractors, and leaders of small companies that had been successful as well as those that have faced challenges—would come together to exchange views and experiences on this topic. He expressed the hope that these views and experiences could help identify some “best practices” and/or new initiatives for the program. The difficult challenge for the NRC committee assessing SBIR, he said, was to evaluate the program as a whole. Given SBIR’s unique role, a key question in analyzing the SBIR program is, “Compared to what?” Answers to this question depend heavily on understanding the context in which SBIR operates. He concluded by emphasizing the need for policymakers to appreciate the challenges of technology transition in particular and the risks and complexity of early-stage finance in general. Fortunately, he observed, the National Academies had assembled a distinguished committee with an exceptional chairman to take up this task. He then introduced Dr. Gansler of the University of Maryland, who is the chair of the NRC Committee evaluating SBIR.