Panel V

Helping Small Business:
Current Trends and Programs

David Audretsch
Director, Institute for Development Strategies
Indiana University

Dr. Audretsch, an authority on the relationships among government policy, innovation, and entrepreneurship, opened the panel by noting that small businesses play similar roles in the both United States and Germany. Most notably, small firms are credited with creating virtually all new jobs. “Both countries undertake impressive policies to promote their small firms,” he said. “But what strikes most observers of small business in Germany is what’s called the Mittelstand, the so-called hidden champions.26 You get a sense of stable, long-term small- and medium-sized firms that don’t come and go as they do in America. In the United States we have more of an entrepreneurial tradition, where the goal is to grow, and the alternative is to disappear.” He welcomed the “two wonderful speakers to help us highlight both systems.”


26The Mittelstand, or “mid-level,” companies (generally considered to include both SMEs and family-owned businesses) include some 70 percent of all private-sector employees in Germany, according to the Institut für Mittelstandforschung. They are concentrated in the sectors of machine tools, auto parts, chemicals, and electrical equipment, and many are export-oriented.

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PROCEEDINGS 105 DAY 2 Panel V Helping Small Business: Current Trends and Programs Moderator: David Audretsch Director, Institute for Development Strategies Indiana University Dr. Audretsch, an authority on the relationships among government policy, innovation, and entrepreneurship, opened the panel by noting that small businesses play similar roles in the both United States and Germany. Most notably, small firms are credited with creating virtually all new jobs. “Both countries undertake impressive policies to promote their small firms,” he said. “But what strikes most observers of small business in Germany is what’s called the Mittelstand, the so-called hidden champions.26 You get a sense of stable, long-term small- and medium-sized firms that don’t come and go as they do in America. In the United States we have more of an entrepreneurial tradition, where the goal is to grow, and the alternative is to disappear.” He welcomed the “two wonderful speakers to help us highlight both systems.” 26 The Mittelstand, or “mid-level,” companies (generally considered to include both SMEs and family-owned businesses) include some 70 percent of all private-sector employees in Germany, according to the Institut für Mittelstandforschung. They are concentrated in the sectors of machine tools, auto parts, chemicals, and electrical equipment, and many are export-oriented.

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106 MEETING GLOBAL CHALLENGES THE “MITTELSTAND” PROGRAMS AND INNOVATION IN GERMANY Rainer Jäkel Head, Directorate for Technology and Innovation Policies Federal Ministry of Economics and Technology (BMWi) Dr. Jäkel said that it was a big honor to participate in this workshop, and urged his fellow participants not to forget “the ‘i’ at the end of BMWi, “because I hope we are as innovative and successful as the company that uses the ‘i’ in front of its products.” He also greeted colleagues from the US federal agencies, especially the National Institute of Standards and Technology (NIST), because “a lot of what we do is closely related to what NIST is doing. One is to support SMEs, and we are also responsible for the German Metrological Institute and the Institute for Materials Research.” He said he had been honored twice to visit NIST. Dr. Jäkel offered several remarks about the strengths and weaknesses of German programs that support small and medium-sized businesses. He reiterated Mr. Schütte’s observation that Germany has a high proportion of innovative and research-intensive companies, many of which are medium- sized. Of the total R&D expenditures in Germany, more than two-thirds are made by companies, with the state responsible for only a small proportion. “I think this is a sign of the strength,” he said, with the result that Germany is a large exporter of technology products, ahead of the U.S. and Japan. The more significant strength, he added, is the well-trained human capital, especially of engineers and skilled workers. Germany's economic strength is reflected by its standing as by far the largest applicant for patents at the European Patent Office. No less important, he said, is the excellent research infrastructure, with the Fraunhofer institutes playing a lead role in technology transfer. Equally significant the roles are played by the Max Planck, Helmholtz, and Leibniz Institutes. He noted that all of these strengths were confirmed by a new survey released shortly before the symposium by the American Chamber of Commerce in Germany. Among weaknesses, Dr. Jäkel said, was that much of the country’s R&D is confined to only a few sectors, notably the automotive sector, which accounts for a more than a fourth of R&D expenditures; machine construction; electrical engineering, and a few others. On the other hand, he noted, much advanced technology developed in these industries finds its way to uses in media industries and other traditional areas; this integration of advanced technologies into traditional areas he saw as a particular strength. A weakness that had already been described, he said, was the “substantial deficit” in start-up financing and venture capital, especially when compared to the U.S. “This is a weakness that we must do something about,” he said. The education system is also underfinanced, he said, which poses a grave

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PROCEEDINGS 107 potential burden for the future. This shortage of skilled workers is brought about by demographic change, which promises to become more acute. Given these weaknesses, Dr. Jäkel said, the German government had made the courageous decision, in the midst of a financial crisis, to elevate the support for research, development, and training in its High-Tech Strategy for 2020. It decided to invest six billion Euros in R&D in the current legislative period, and six billion in the education system. “We had a large consensus from all the major parties,” he said, “that our future depends on innovation, research, development, and education, and that this is not the moment to economize.” He said that the investment by the private sector did not drop significantly, while the state contribution increased. He turned to the very large number of SMEs, calling them “the backbone of industry.” These have often been family businesses for three, four, five or even more generations, and he stressed that “these companies have a very long-term orientation. They are not focused on the next board meeting, or the next business cycle, but very much on the long run.” As an example, Dr. Jäkel recalled visiting one of these “hidden champions,” a company located “behind the seven mountains,” or in the countryside, but with close regional ties to educational and research institutions. This family firm had worked with these institutions from generation to generation, continually re-inventing itself according to new opportunities. The father and the grandfather had long made jukeboxes and cigarette machines, but now the company had upgraded its skills to become a global leader in electronic connections for urban use and also plug-in connections for wind turbines and similar facilities. The current owner is working in robotics with help from the German Institute for Artificial Intelligence. “So you can see the evolution of this company over a short time period—the company remains the same, with the same family name, but it is reinventing itself, as are many SMEs in Germany.” German innovation policy, he said, is designed to prepare the ground for the future for these companies. Most important, he said, is the economic framework, especially for SMEs that are not in a position to move their sites. Equally important is the issue of entrepreneurship in Germany, so that new companies enter the market and stimulate competition. It is also important that existing SMEs are assisted in using the research facilities of universities. Addressing the broader concerns of SMEs, Dr. Jäkel said that taxes are always a major issue, despite a recent reduction of the corporate tax to be more competitive globally. One problem has been that German capital receives worse treatment than foreign capital within the tax system, which affects the health of the VC industry. Another drawback, he said, “is the loss of contracts, which is important particularly in biotechnology, because in Germany the use of debit carryovers is limited.” He said that this situation had not yet been remedied, because “unfortunately, finance ministers think differently than innovation leaders.” An important need is a stronger infrastructure for patent rights and other intellectual property. “We are in the midst of creating a European

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108 MEETING GLOBAL CHALLENGES Community patent, and shrinking the language regime from 21 to three— namely English, German, and French. This would reduce the cost of patents for SMEs significantly.” Another important issue for SMEs, he said, was the standardization of technology transfer and research processes. This issue, he said, was receiving a high priority. SMEs also stood to benefit from some of the reforms planned for the educational system, Dr. Jäkel said. While SMEs focus on activities from the creation to the marketing of goods, the general need to strengthen R&D justifies the involvement of the state. Problems include adequate funding of R&D projects for SMEs, which banks are reluctant to underwrite. A second is that for SMEs to be sustainable, they depend to some degree on universities’ research facilities. “Therefore, the central point of our policy is to strengthen cooperation between SMEs and research institutions.” He noted that the Ministry of Research had opened a window specifically to connect SMEs with the high- technology trade program of the Ministry of Research. In regard to entrepreneurship, he described a program called EXIST that encourages universities and research institutions to familiarize students with entrepreneurial thinking. The program supports students and research staff in efforts to create business plans and develop marketable processes and products. Referring to earlier discussions about the weakness of the German private market in funding startups, Dr. Jäkel said that five or six years ago a public-private partnership between government and industry took a positive step to remedy that problem. It created a start-up fund with 240 million Euros in state funds and 32 million Euros in funds from corporate partners. The goal of the fund is to help young companies financially in their first year, with a particular focus on high-tech companies. Committees appointed by business experts and venture capitalists select promising fields to support. The program had yielded positive results, partly because the funding is managed by the recipient companies themselves. Furthermore, ever since the first round of direct financing, a number of private businesses and venture capital funds had joined the program. As a result, a second fund was planned by six German industrial companies and at least 10 partners’ companies. A small but important area for new businesses, he said, is “innovation consulting,” which makes new companies aware of the importance of innovative strategies and management. A flagship program is the Central Innovation Programme Mittelstand, launched in 2009. It promotes cooperation between SMEs, and between SMEs and universities or research institutes. In addition, it supports individual project managers in specific companies that need assistance as they develop products and bring them to the marketplace. His agency had used various partners to manage these programs, including competitively selected private service providers that specialize in assessing R&D projects. This strategy had worked well, Dr. Jäkel said, with the agencies acting and reacting flexibly to administer a large stimulus program. The maximum amounts for each SME were not large, he said, but the stimulus program had increased the amounts by 40 to 50 percent.

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PROCEEDINGS 109 An important feature of the program, he said, is its bottom-up design. It is open to any field of technology and does not require fixed delivery dates. The SMEs can access their funding at any time, for any topic that is important to them. International corporations can also be supported, primarily within Europe. The program has received almost 20,000 applications in just over two years; 13,000 were approved, and the rate of applications is projected to continue at about 6,000 per year. He noted that the program was also successful in fast turn-around times. Well-structured applications can be processed and approved within two to three months, and in some cases faster. Dr. Jäkel also emphasized the importance of cooperation in the program’s success. It targets small companies of two sizes—10 to 50 employees and 50 to 250 employees—with a strong focus on engineering and production, materials, electrical equipment and instruments, and IT. In many partnerships, high-tech firms bring new abilities to traditionally low-tech industries. In textiles, for example, the company was not doing traditional low-tech production, but integrating techniques like nano-coating. In such ways, he said, the low-tech industries become higher-tech, partly through the structural aids of the program. He added that a special feature of innovation in Germany is its communal industrial research, by which many branches of industrial sectors have, for more than 50 years, maintained research associations to monitor the particular needs of those branches. Such monitoring usually precedes competitions, and the results of the competitions are often made public. These projects are wholly run by the private sector, and the members of the monitoring committees come from SMEs. Large companies have their own loan program that provides larger amounts of funding. In summary, Dr. Jäkel said, that a central goal of his Directorate is to strengthen the innovative capacity of German SMEs, sustain their essential role in the major industrial networks of Germany, and support their success in the global markets. “We want to encourage this mainly through incentives,” he said, “ranging from entrepreneurship to total funding and research development projects. In addition, we want to strengthen the education system and face the problem of our aging population. This is a particular issue in Germany, and quite different from the U.S., which is a classic immigration country that constantly adds new, well-trained people to their human capital. As for our SMEs, however, we are in good shape, and I hope this will continue.”

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110 MEETING GLOBAL CHALLENGES SMALL BUSINESS INNOVATION: FEDERAL INVESTMENTS TO CROSS THE VALLEY OF DEATH Charles W. Wessner Director, Technology, Innovation, and Entrepreneurship The U.S. National Academies Dr. Wessner opened his talk by saying that the Obama Administration had “shown great sensitivity to innovation policy,” and had developed “coherent and broad-ranging policies” to address the “mega-challenges” discussed by previous speakers, including economic growth, developing sustainable energy, slowing climate change, delivering global health, and improving national security. One theme of the meeting, he suggested, was that innovation is essential in redesigning the path forward. He described this “innovation imperative” under three headings: • Innovation is key to addressing global challenges and strengthening a country’s competitive position. • Collaboration among private firms and universities is essential to capitalize on investments in education and research. • New partnerships are needed to foster innovation and collaboration. Competition in the 21st century is based on innovation, he continued. In terms of policy, the key challenges in sustaining innovation are to fortify national R&D budgets, create a positive environment for innovation, support high-tech innovation clusters, and use innovation awards to “provide oxygen” for the process itself.27 Innovation was a central motivation in formulating the “Lisbon agenda” of the European Union, in which European leaders pledged to invest 3 percent of each nation’s GDP in research and development. Since then there has been some progress in the EU and the United States, but total R&D spending by leading nations in East Asia have collectively passed Europe in 2003, and is approaching that of the United States.28 27 Innovation is often linked with invention as part of the creative process. While invention may refer to a new product or idea, innovation is the use or commercialization of the invention. More detailed is the definition of Joseph Schumpeter: “The introduction of new goods (…), new methods of production (…), the opening of new markets (…), the conquest of new sources of supply (…) and the carrying out of a new organization of any industry.” A simpler version is that of the American Heritage Dictionary: “The act of introducing something new.” 28 R&D expenditures for the United States, EU-27, and Asia-8 economies: 1996-2007, National Science Board, Science and Engineering Indicators 2011, Arlington, VA: National Science Foundation, 2011.

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PROCEEDINGS 111 The United States does make “very substantial investments” in R&D, Dr. Wessner said. The U.S. share of global R&D in 2010 was $415 billion out of total global R&D expenditures of $1.25 trillion.29 Japan’s share was $148 billion, China’s share $149 billion, and Germany’s share $83 billion. In the United States, about two-thirds of R&D spending came from private sources and one-third from public sources. An overarching problem is that the federal investment in R&D as a percentage of GDP has been declining since the early 1960s. And the private sector, pressured by competition from Asia and Europe, has devoted more of its R&D spending to applied research and development. In addition, the approximately $148 billion in federal R&D spending is skewed away from fundamental discovery. Of the defense R&D budget, which accounts for more than 50 percent of federal R&D spending about 90 percent is spent on development.30 “We overstate what we spend on R&D, and should not be congratulating ourselves on this overall share,” Dr. Wessner said. On a positive note, the federal government does invest generously in health care research, Dr. Wessner added, which has the potential to bring enormous opportunities for our well-being and productivity. Some Risks to the Innovation System Dr. Wessner enumerated some major risks to the U.S. innovation system. The first was complacency among many of our policymakers about the nation’s competitive position in the world. There is little understanding, he said, of how hard this nation has worked to achieve its leadership position in R&D, and how much more is needed to maintain this position. A second risk is the focus on current consumption rather than investment for the future. After 12 tax cuts during the past three administrations, he said, “we are not making the investments our fathers made. This can only reduce the opportunities our children will have.” Finally, there is too much emphasis on research alone and not enough on its development and commercialization. Too many promising products and prototypes “are gathering dust on the shelves of laboratories around the country” without reaching the marketplace. At the same time, he said, the U.S. has important strengths that give reason for optimism: • The public values science and technology, and trusts authorities to maintain high standards and safety. 29 Organisation for Economic Co-operation and Development, Main Science and Technology Indicators, Paris: Organisation for Economic Co-operation and Development, 2008. 30 American Association for the Advancement of Science, 2010.

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112 MEETING GLOBAL CHALLENGES • The culture places high social value on commercial success, and allows those who fail to try again. “We admire people who can create wealth out of new ideas.” • The United States has entrepreneur-friendly policies and markets that are truly open to competition. “You can enter the market with a new idea without being excluded by an oligarchy.” • A strong IP regime encourages research and the diffusion of research results. • U.S. bankruptcy law allows a person to not only build up a company in the United States, but also to terminate it and start again if an innovation should falter. “In Europe, there is still a legacy of punishing people who fail.” Dr. Wessner cited the pioneering work of David Audretsch and others in documenting why small innovative companies are key players in bringing new technologies to market. Small businesses, he said , grow jobs, increase market competition, generate taxable wealth, create welfare-enhancing technologies, and, over time, transform the economy.31 At the same time, small, innovative businesses face major challenges. The first is high regulatory burdens. One recent study concluded: “In the distribution of federal regulatory costs, a disproportionately large share falls on small businesses. Very small firms (fewer than 20 employees) fare the worst, spending 45 percent more per employee than large firms to comply with federal regulations.32 In addition, new firms struggle for adequate financing. They are often forced to depend on “friends, family, and fools,” with banks hesitating to lend to small businesses.33 The Peril of the Funding Gap Many people assume that small companies routinely turn to venture capital firms for support, but this is true only for those with a track record and preferably revenues. Between the stage where the individual and perhaps friends or family sustain a young company, and the stage where VC firms are interested, looms a significant gap (popularly called the “Valley of Death”) that has widened over the years. Just below the level at which VC firms typically invest are angel investors (usually individuals), who may be able to provide a million or so dollars, but a VC firm will seldom take an interest in an investment of less 31 “Between 1980 and 2005, virtually all net jobs created in the United States were created by firms that were five years old or less.” Robert Litan, Kauffman Foundation, 2010. 32 Mark Crain, “The Impact of Regulatory Costs on Small Firms,” SBA: SBHQ-03-M-0522, Washington, DC: Small Business Administration, 2005. 33 Wall Street Journal, “Loan Squeeze Thwarts Small-Business Revival,” March 15, 2010.

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PROCEEDINGS 113 than $2 to $10 million, and in return will expect a fairly rapid and substantial payback. As Dr. Wessner pointed out, “Venture capital is not an institution designed to help the poor. Its objective is to come in late, get out early, and make money for those who invest in the fund.” Unfortunately, he said, a common myth in Washington, especially in the Congress, is that if an idea for a company is a good one, the market will fund it. In reality, potential investors have less than perfect knowledge, especially about innovative ideas; this “asymmetric information” leads to suboptimal investments.34 In addition, venture capitalists are prone to herding tendencies, prefer less risky stages of development, and allocate only about 8 percent of their funds to “seed stage” firms. Tools to Help Avoid the ‘Valley of Death’ Fortunately, Dr. Wessner said, the federal government has developed several tools to help firms avoid the Valley of Death; foremost among them is the Small Business Innovation Research (SBIR) program. The program is stable, having been in place for 25 years, and, as a set-aside mechanism, it currently allocates a steady 2.5 percent of each federal agency’s R&D budget to small business awards and contracts. Total spending is about $2.5 billion a year, large enough to achieve a portfolio affect over a number of years. It is also decentralized over 11 agencies so that every agency can be an “innovation agency.” SBIR has several conceptual advantages, he said. It uses a rigorous, double-gated competition, with only about 20 percent of applicants accepted for Phase I. It is flexible enough to allow candidates to try again if they fail. Because recoupment is through the tax system, grants and contracts lower the risk faced by prospective entrepreneurs. After nearly two decades of operation, the Congress asked the National Academies to assess the program; in turn, the Academies found SBIR to be “sound in concept and effective in practice.” Some favorable aspects of the program are that loans don’t have to be paid back, a company can keep its IP, and approval by SBIR achieves a “certification effect” that raises the profile of awardees as potential investments for venture capitalists. It also helps to create new companies and to support existing companies. SBIR is, in effect, an innovative procurement tool for the government and a low-cost technological probe to explore new ideas. It responds quickly to urgent national needs and diversifies the government’s supplier base. University faculty don’t have to give up their positions to participate, and an applicant does not need to found a 34 George Akerlof, Michael Spence, and Joseph Stiglitz received the Nobel Prize in 2001 for their analyses of markets dependent on asymmetric information.

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114 MEETING GLOBAL CHALLENGES company to apply. It helps link universities with companies and creates new spin-outs. “The fact that a high proportion of [SBIR] projects reach the marketplace in some form is significant, even impressive,” the report concluded.35 Measuring the Success of the SBIR SBIR success has been measured in many ways. It increases employment by helping new startups grow and creating high-quality jobs. It promotes innovation, as indicated by numbers of new products, patents, licenses, and publications. It helps federal agencies meet success in their missions through acquisition and procurement. As examples, NASA uses SBIR-funded lithium-ion batteries to power the Mars Rover, and DoD uses SBIR-developed armor to shield against IEDs. The SBIR certification effect can be seen through program “alumni” that are successful as public companies, including Qualcomm, ATMI, Martek, and Luna.36 The potential role of SBIR funding is well illustrated in the example of A123, an innovative battery company in Massachusetts. The research for A123 was done at MIT, where NSF funds had helped develop a technology based on “an advanced cathode material for lithium-ion batteries.” When the inventors decided to form a company, they won an SBIR award from the Department of Energy to help develop the core technology, which has applications for computers, power tools, and hybrid-electric vehicles. Then a $250 million grant from the government led to VC funding and finally an IPO. By May 2011 the company had a market capitalization of $712.3 million. The SBIR is sometimes criticized for “intervening” in the marketplace, said Dr. Wessner. He said that a more accurate image of SBIR is a market- oriented procurement program that creates new information for the market about the technical feasibility and commercial potential of innovations. It then draws more participants into the program, introduces new products to the market, and lets the market decide whether the innovation is worth converting into solutions for social problems. “This is the same challenge you have in Germany, and that every country has. We would argue that the policy framework matters immensely, and that the SBIR is one proven policy tool.” 35 National Research Council, “An Assessment of the SBIR Program,” Charles W. Wessner, ed., Washington, DC: The National Academies Press, 2008. 36 Irwin Jacobs, founder of Qualcomm, told Congress, “Getting the grants translated into stamps of approval that allowed Qualcomm to pursue other sources of private capital.” Congressional Testimony, February 2011.

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PROCEEDINGS 115 In conclusion, he posed several questions for his German colleagues: • Are there programs that provide incremental early funding that allow Mittelstand companies to cross the Valley of Death? • Which programs bring sufficient resources to reach critical mass? • Which programs allow small firms to gain access to the public procurement process? In closing, Dr. Wessner suggested that a common challenge for Germany and the United States was to adjust to and help shape the new globalization dynamic. “This may involve initiating change through competitive incentives and major investments. Learning and cooperation are essential for both of our countries.” DISCUSSION Ambassador Wolff asked about the nature of the cooperation between small firms and the Fraunhofer Institutes or federal entities. “Does the government transmit technical assistance? Is the goal for the SME to become a large enterprise, and does that happen? Do they become major competitors, like Qualcomm?” He also asked whether the SBIR program provided only funding or also technical assistance. Dr. Jäkel said that while the SBIR program is oriented toward mission needs of federal agencies, the German support is oriented to the needs of the companies. “We want to help them bridge the financing gap,” he said. “Banks don’t give enough money for R&D because it’s too risky. We help them cooperate with Fraunhofer, and also research institutions, universities, SMEs, and others. I think it is a good model of how technology and knowledge transfer can succeed.” He said that direct cooperation between an SME and a university facilitates a direct transfer of research to a company. “We want them to grow, but in the end it depends on them. If we look at hidden champions, or global SMEs, they integrate to the region even while half of their employees are abroad. Many have grown from dozens to thousands of employees.” Dr. Wessner said that in regard to SBIR, it provides no formal technical assistance, but often a program manager can offer valuable information and collect feedback. A number of agencies already provide market training. This is necessary because many of the company leaders are professors, many of whom require help in hiring someone with experience running a company. Helping companies scale up their production and grow remains difficult, and the causes are not always clear. A questioner asked about the Manufacturing Extension Program in the United States, which helps SMEs acquire new skills, such as lean manufacturing. He asked whether Germany offers a similar service, or whether companies learn from the Fraunhofers.

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116 MEETING GLOBAL CHALLENGES Dr. Jäkel said that the answer was “both.” A special program offers small SMEs various consulting services and a small grant of 15,000 Euros. The companies learn in cooperation with Fraunhofers and others how to develop their business, and how to collaborate in networks and clusters. Dr. Prabhakar asked about the goal of the program to support SMEs. Dr. Jäkel said that it is a bottom-up program, open not only to all kinds of technologies but different strategies, with the main focus on cooperation. “That’s what SMEs need. They need knowledge of research institutions, but also ability to do some R&D on their own, and they get partners for that, and also support networks. We bring together knowledge to let them be more successful in the market.” Dr. Neuhoff asked whether the SBIR program held open calls for proposals. Dr. Wessner said the calls were not open, and can be quite specific in their goals, such as developing a new material or building certain equipment. “An advantage is that it lets people bring in their own ideas. It is abused when agencies tell companies what they want.” Dr. Jäkel added that the Center Innovation Program for SMEs had no calls at all. Instead, companies can apply as they wish, and even receive help in designing their project. About 65 to 70 percent are approved; he said that while that figure may sound high, most weak projects are already screened out beforehand by agencies.