Executive Summary

The Small Business Innovation Research (SBIR) program was created in 1982 through the Small Business Innovation Development Act. SBIR offers competition-based awards to stimulate technological innovation among small private-sector businesses while providing government agencies new, cost-effective, technical and scientific solutions to meet their diverse mission needs.”1

During the first two decades of the program, some majority venture-funded companies participated in the program, receiving SBIR awards in conjunction with outside equity investments. During this lengthy period, the participation of majority venture-funded firms was not an issue. They participated in the SBIR program throughout this period without any apparent adverse consequence for the operation and achievements of the program.

THE 2002 SBA DIRECTIVE

In a 2002 directive, the Small Business Administration ruled that to be eligible for SBIR the small business concern should be “at least 51 percent owned and controlled by one or more individuals who are citizens of, or permanent resident aliens in, the United States, except in the case of a joint venture, where each entity to the venture must be 51 percent owned and controlled by one or more individuals who are citizens of, or permanent resident aliens in, the United

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As stated in the Small Business Innovation Development Act (PL 97-219), the program’s goals are four-fold: “(1) to stimulate technological innovation; (2) to use small business to meet federal research and development needs; (3) to foster and encourage participation by minority and disadvantaged persons in technological innovation; and (4) to increase private sector commercialization derived from Federal research and development.”



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Executive Summary The Small Business Innovation Research (SBIR) program was created in 1982 through the Small Business Innovation Development Act. SBIR offers competition-based awards to stimulate technological innovation among small private-sector businesses while providing government agencies new, cost-effective, technical and scientific solutions to meet their diverse mission needs.” 1 During the first two decades of the program, some majority venture-funded companies participated in the program, receiving SBIR awards in conjunction with outside equity investments. During this lengthy period, the participation of majority venture-funded firms was not an issue. They participated in the SBIR program throughout this period without any apparent adverse consequence for the operation and achievements of the program. THE 2002 SBA DIRECTIVE In a 2002 directive, the Small Business Administration ruled that to be eli - gible for SBIR the small business concern should be “at least 51 percent owned and controlled by one or more individuals who are citizens of, or permanent resident aliens in, the United States, except in the case of a joint venture, where each entity to the venture must be 51 percent owned and controlled by one or more individuals who are citizens of, or permanent resident aliens in, the United 1As stated in the Small Business Innovation Development Act (PL 97-219), the program’s goals are four-fold: “(1) to stimulate technological innovation; (2) to use small business to meet federal research and development needs; (3) to foster and encourage participation by minority and disadvantaged per- sons in technological innovation; and (4) to increase private sector commercialization derived from Federal research and development.” 1

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2 VENTURE FUNDING AND THE NIH SBIR PROGRAM States.”2 This new interpretation of “individuals” resulted in the denial by the SBA Office of Hearings and Appeals of an SBIR grant in 2003 to Cognetix, a Utah biotech company, because the company’s equity was more than 50 percent owned by private investment firms. The ruling, issued by an Administrative Law Judge, stated that venture capital firms were not “individuals,” i.e., “natural persons,” and therefore SBIR agencies could not give SBIR grants to companies in which venture capital firms had a controlling interest. The effect of this direc - tive has thus been to exclude companies in which venture capital firms have a controlling interest.3 DIVERGENT CLAIMS ABOUT THE IMPACT OF THE SBA DIRECTIVE No empirical assessment of the likely impact of this new interpretation was made before the SBA ruling was implemented. Since then, claims about its impact have been made by both proponents and opponents, but both appear overstated. Those who support the SBA ruling predict that eliminating the new interpretation of the rule could lead to the participation of firms controlled by large venture capital firms, including venture capital arms of major industrial corporations such as General Electric or Intel, and argue that this outcome is contrary to the mission of the SBIR program. Arguing against this position, the National Institutes of Health, biotechnology companies, and the Biotechnology Industry Organization (BIO) have argued that the new eligibility requirements have a negative impact on the NIH mission and on the ability of high-technology firms to develop and commercialize promising new biomedical technologies. CALL FOR AN EMPIRICAL ASSESSMENT BY THE NATIONAL RESEARCH COUNCIL To better understand the impact of the SBA exclusion of firms receiving ven- ture funding (resulting in majority ownership), the NRC proposed that the NIH study be extended to include this empirical analysis by the NRC.4 In particular, 2Access the SBA’s 2002 SBIR Policy Directive, Section 3(y)(3) at . 3 See Appendix F. 4As the SBIR program approached its twentieth year of operation, the U.S. Congress requested the National Research Council (NRC) of the National Academies to “conduct a comprehensive study of how the SBIR program has stimulated technological innovation and used small businesses to meet Federal research and development needs” and to make recommendations with respect to the SBIR program. Mandated as a part of the SBIR reauthorization in late 2000, the NRC study has assessed the SBIR program as administered at the five federal agencies that together make up some 96 percent of SBIR program expenditures. The agencies, in order of program size, are the Department of Defense (DoD), the National Institutes of Health (NIH), the National Aeronautics and Space Administration

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3 EXECUTIVE SUMMARY this empirical analysis addresses two key questions that bear on the policy issue at hand. These are: • How many firms have been or are likely to be excluded by the ruling from participation in the NIH SBIR program? • What is the likely effect of this exclusion on these firms and on the NIH SBIR program? MAIN CONCLUSIONS OF THE ACADEMIES’ STUDY The Academies’ study finds that between 4.1 percent and 11.9 percent of firms that won SBIR Phase II awards from NIH between 1992 and 2002 have been excluded, or possibly excluded, from the program because of the SBA ruling. (See Table 3-4.) While the evidence is narrowly based and is by no means precise, it does also suggest that the impact of the ruling falls disproportionately on the most promising firms—i.e., those firms that have repeatedly been selected by both NIH for their promising technologies and by venture investors for their commercial potential. Firms that are venture-funded are somewhat less likely to commercialize but are much more likely to generate substantial sales from their SBIR-funded projects when they do commercialize than are firms that receive SBIR funds but are not venture-funded. Restricting access to SBIR funding for firms that benefit from venture invest - ments would thus appear to disproportionately affect some of the most commer- cially promising small innovative firms. To this extent, the SBA ruling has the potential to diminish the positive impact of the nation’s investments in research and development in the biomedical area. It is important to note that the task of identifying firms that have received ven- ture funding is a challenge. SBIR-funded firms, which are in most cases privately held, are not required to reveal whether they have received third-party investment. As a result, this information is not collected and stored by SBIR-funding agencies or SBA. Chapter 2 of this report explains the study methodology. By selecting out some of the most commercially promising innovative small firms, the SBA directive appears to limit opportunities to exploit the nation’s substantial investments in research at NIH. This is contrary to one of the four key goals of the SBIR program, which is the commercialization of federal research. 5 Although the evidence is not definitive, the implementation of the SBA ruling (NASA), the Department of Energy (DoE), and the National Science Foundation (NSF). For an over- view report of this assessment, see National Research Council, An Assessment of the SBIR Program, Charles W. Wessner, ed., Washington, DC: The National Academies Press, 2008. 5The goal of private-sector commercialization was moved in priority from being listed fourth when the program was initiated in 1982 to second in the 1992 reauthorization of the SBIR program.

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 VENTURE FUNDING AND THE NIH SBIR PROGRAM appears to be negatively affecting current participation by firms and the long-term commercialization potential of the NIH SBIR program.6 Based on the Committee’s analysis of the impact of restricting venture fund- ing on the NIH SBIR program and its experience in the larger evaluation of SBIR programs at five agencies, the Committee recommends that consideration should be given either to restoring the de facto status quo ante eligibility requirements for participation in the SBIR program or to making some other adjustment that will permit the limited number of majority venture-funded firms with significant commercialization potential to compete for SBIR funding.7 6 See the Committee’s findings in Chapter 7 of this report. the Committee has not analyzed the impact on firms applying for SBIR grants from federal agencies other than NIH. It would be worth examining the impact of restricting venture funding on the SBIR program at other federal agencies. 7The Committee has published separate assessments of the SBIR programs at the Department of Defense, at the National Institutes of Health, the Department of Energy, the National Aeronautics and Space Administration and the National Science Foundation. In addition, the Committee has published a comprehensive overview report of the program’s operations, achievements, and challenges. See National Research Council, An Assessment of the SBIR Program, op. cit.