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Pane! V Program Challenges Operational Views INTRODUCTION Dan Hill Small Business Administration SBIR's Origins Mr. Hill opened the session by recalling an exchange that took place at a congressional hearing in 1982, the year the SBIR program was created, between then-Sen. Warren Rudman (R-N.H.) and an official of the National Science Foun- dation (NSF). The NSF official was complaining about the proposed SBIR as a new set-aside program when Sen. Rudman asked him how many of the agency's R&D awards had gone to small business. The answer was that, in the history of NSF support for R&D, not a single award had been made to a small business entity. Mr. Hill then quoted the Senator's reply: "'Is not it true we are not really creating a new set-aside, we are just destroying the old one?"' Discussions of the "quote-unquote 'tax"' that SBIR funding is said to constitute, Mr. Hill argued, often lose sight of the reason for which SBIR was created: to bring cost-effective, highly innovative small businesses into federal R&D programs. Second, while backing the call for further examination of the program, Mr. Hill asked that future studies compare its effectiveness to that achieved through the expenditure of the remaining 97.5 percent of federal R&D funds. He objected to what he sees as a pervasive tendency to set a standard of success for SBIR that is "arbitrarily higher" than standards applied to other programs. A comparison such as that he was advocating would yield results favorable to SBIR, 80

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PANEL IV 81 he predicted, claiming that small businesses, despite their meager share of federal R&D funding, outperform large companies and universities in obtaining patents. Concurring with Rep. Davis's judgment that times have changed, Mr. Hill recommended that the coming debate on SBIR's reauthorization not be domi- nated by the question of how R&D funding is to be split up among the various research institutions. Instead, it should focus on enlarging the R&D funding pie itself, while at the same time affirming the principle that investing in the nation's R&D needs is a good way to spur economic development. The Small Business Administration (SBA) has taken a position in favor of forming new partnerships and "new friendships" with industry and universities. Acknowledging that not all universities support the SBIR program, he observed that a sea change under way in the academic world is being viewed by SBA as an encouraging sign. Issues in SBIR's Reauthorization While stressing that SBA believes the SBIR program can be improved, he cautioned against the emphasis on legislative remedies that had been mentioned at the symposium to that point, saying that many of the issues raised can be addressed administratively under existing legislation, either agency by agency or across the board. He expressed his eagerness, as SBA Assistant Administrator for Technology, to hear the suggestions of meeting participants, and he promised to take them up with program managers at the participating agencies. He then concluded by presenting a list of the programmatic and operational issues he believes to be facing the program in the run-up to reauthorization: . Commercialization: What value should be assigned by the participating agencies to a firm' s ability to commercialize? At what point in the process should commercialization potential be considered a factor in awarding a SBIR project? What is commercialization, and does the definition vary industry to industry or agency to agency? Cost-sharing: Should SBIR agencies be allowed to decide awards based on the amount of cost-sharing provided by an applicant? Does this really advance the purpose of SBIR? Multiple award winners: According to Mr. Hill, authority currently exist- ing at agencies is sufficient to limit those multiple award winners that are not contributing to mission needs or are not active in commercialization. He urged an examination of whether funding from the remaining 97.5 percent of the federal R&D budget tends to become concentrated among a limited number of large corporations and universities and whether a higher standard is being set for small business.

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82 THE SMALL BUSINESS INNOVATION AND RESEARCH PROGRAM . Time delays: Does too much time pass between the end of a solicitation period and the issuance of a Phase I award and between Phase I and Phase II? How long should agencies take, and is a congressional mandate needed to set that limit? Geographic distribution: Is the answer to uneven geographic distribution of awards to set up a quota system, or are there other remedies such as outreach? Evaluative criteria: Agreeing that evaluative criteria for both SBIR and the Small Business Technology Transfer program must be improved, he noted that SBA had agreed with the recommendation of the House Com- mittee on Science to make the programs subject to the Government Per- formance and Results Act (GPRA). In an upcoming report, SBA will provide both the Science and Small Business committees with language that has been instituted by the agencies that participate in the SBIR pro gram to show that they are within GPRA. He called in addition for sug- gestions from the small business community and Congress on what might be done to evaluate the SBIR program other than placing it under GPRA. Three-phase approach: Does this approach make sense and should it be continued? Although he predicted that raising this question would cause "consternation" on the part of many in attendance, Mr. Hill reported that several agencies had approached him to ask whether they could skip Phase I and go directly to Phase II. Seeing good arguments on both sides, he said that the issue should be examined. Set-aside percentage: While SBA would like to see the percentage of R&D funds reserved for SBIR go up, it would prefer to see the total federal R&D budget go up. Outreach to the underserved: This is a major issue in the SBIR program as it is in other programs run by SBA, which believes that parts of the small business community especially women and minorities have not tradi- tionally been reached. The agency, Mr. Hill said, does "not buy into the argument that there are not enough women technology owners out there to fill this market void." Administrative costs: SBA would argue against allowing administrative costs to be part of SBIR, believing that the program's budget for awards is small enough without "taking more money from small business and giv- ing it to bureaucrats to run the program." The question is a relevant one, however, and SBA is soliciting the opinions of concerned parties.

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PANEL IV 83 BALLISTIC MISSILE DEFENSE ORGANIZATION Carl Nelson Program Manager (ret.) The Question of Subsidies Dr. Nelson, for ten years head of the SBIR program at the Ballistic Missile Defense Organization (BMDO) and its predecessor, the Strategic Defense Initia- tive Organization, called into question at the outset the notion that the government can create wealth by granting subsidies. The standing controversy surrounding direct government subsidies is only heightened at a time when the private venture- capital sector is investing as heavily as it did in 1996 and 1997 when it provided $10 billion and $11 billion, respectively and when angel investors are putting up many times that amount. At present, there is little prospect that these levels of investment will change. Annual return on venture capital has been at about 40 percent for the past four or five years; until the level of returns declines, venture money keeps getting recycled and will thus continue to pour in. Although the market is concerned with return on investment and total return, most SBIR managers and overseers focus on scientific and technical merit. The mission agencies in particular, needing high technology, focus on performance rather than on market aspects or cost. The government does not live in a market world of instant information and instant response nor would that be appropriate, Dr. Nelson said, reminding the audience that "one thing you want from govern- ment is stability." But, attributing "veto power" to the government's internal processes, he warned: "You can not get much done in a federal agency without a consensus of at least half a dozen people, any one of whom can say 'no' and then your proposition is effectively dead." Improving SBIR: Incentives for Program Managers Dr. Nelson put forward suggestions for two ways that SBIR might be im- proved under current legislation, which gives the participating agencies ample operating room to run versions of the program suited to their needs. Each agency should be allowed to either choose its own "empowered decision makers" for the program, or if it is reluctant to move away from committees and place responsi- bility for decisions on individuals adopt a formula, which might resemble the "ingenious" Fast Track pilot instituted by the DoD. Basing a model of the first option on his own experience running the SBIR program at BMDO, Dr. Nelson likened the decision maker to an investment port- folio manager in contrast to a technical committee or branch chief, such as those at the Wright-Patterson or Naval Research laboratories. This decision maker would, within general guidelines provided by the agency head, have the authority

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84 THE SMALL BUSINESS INNOVATION AND RESEARCH PROGRAM to make awards and would, as a result, be held accountable by "some type of objective measure." Incentive would be created by providing a reward perhaps a bonus of $10,000 each for the government's three best empowered SBIR man . . agers In a given year. To judge which managers are the best, some external objective standard would have to be established. Among the possibilities: Return on investment. This is the typical standard in the venture-capital community, but some rethinking would be required to decide what the invest- ment and return were in the context of a government agency. In addition, there is a problem of the time scale. Public capital raised. Calling the amount of public capital raised, particu- larly through initial public offerings, "an excellent measure," Dr. Nelson stated as one of his principles: "If you are not heading toward getting public capital into a technology that's going to become a business [and thus] have real impact, . . . the scale of your thinking is probably too small." Median size of awardee company. Although not necessarily a very good measure of results, this may in light of the number of studies showing that the most innovation per employee comes from firms with under 20 employees be an indicator of whether funding is going to the most innovative part of the small- business community. Using a control group of nonawardee firms, a technique pioneered by Dr. Lerner, would be integral to establishing this as a metric. "Honor Roll" Selections. Another possible metric would consist in count- ing the number of firms in each manager's portfolio that appears on an honor roll of the type published by Forbes, Inc., BusinessWeek, and Deloitte & Touche. Improving SBIR: A Formula Approach The second option, the formula approach, would put a ceiling on the percent- age of an agency's annual SBIR budget that could go to the ensemble of firms that, on an individual basis, already held grants valued at a specified minimum amount; once that ceiling had been reached, these firms would have to compete against one another in a restricted pool. In addition, the ratio of matching funds to SBIR grant funds demanded of an award winner would escalate with the total amount of government money the firm had received under the program. Con- versely, a minimum percentage of funding would be reserved for award to first- time applicants. Limiting the availability of funding to established SBIR winners would cor- rect the current tendency of committees and agency technology heads to award a disproportionate amount of their available money to firms whose technologies

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PANEL IV 85 further their particular interests. This tendency appears to go hand in hand with the choice of narrow topics for SBIR competitions, which Dr. Nelson himself avoided in favor of broad topics. Because agencies may receive "a large number of proposals for a narrow technology, only one or two of which may be really competitive," he contended, a narrow focus is "almost arbitrary from the stand- point of commercialization efficiency." Similarly, in concentrating awards in few hands, program officials "are ignoring the power of the commercial market to develop a technology so that the agency can use it." Requiring that financial contributions by awardee firms escalate with succes- sive awards, as well as setting aside funding for first-time awarders, would be in line with Dr. Nelson's own past practice. At BMDO, however, he based his demand for a rising ratio of matching funds not on the total number of SBIR awards won by a firm but on the number of SBIR awards it had won in support of a particular technology. "I would say that if, by the time you got to the third award, you did not have a large ratio of matching share or money of some sort," he recalled, "there was something wrong with your underlying assumptions about the marketability of your technology." The government's selection process was helping foster what he charged to be a "large measure of self-deception going on" within the SBIR program. Granting Phase I money to first-time applicants- which he did in the case of almost any new bidder with an "innovative-sounding idea that at least the technical experts did not say violated the Second Law of Thermodynamics" and instituting schemes such as Fast Track that are designed to demonstrate private-sector interest in a technology are essential, in his opinion, "if you are going to get a wheel invented not reinvented." PARALLAX RESEARCH, INC. David O'Hara President Mr. O'Hara began by emphasizing the record of nongovernment sales estab- lished by his company, a maker of x-ray optics included in x-ray analytical instru- ments, primarily for the semiconductor industry. Parallax got its start in 1994 with the help of a SBIR award from BMDO. Sales to nongovernment customers accounted for only a few percent of gross revenues in 1995, but that percentage climbed to about 10 percent in 1996 and about 25 percent in 1997. It is projected to reach somewhere on the order of 60 percent for 1998. Personal Perspectives on SBIR Although this record contrasts sharply with that of the company that em- ployed Mr. O'Hara before he founded Parallax Research, it was shaped in large part by the perspective he gained working there. His former employer, also a

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86 THE SMALL BUSINESS INNOVATION AND RESEARCH PROGRAM small firm, had repeated success in obtaining SBIR awards the proposals for many of which were written by Mr. O'Hara himself but was never able to com- mercialize. This company eventually received a letter from Dr. Nelson accompa- nying a Phase II award stating that before receiving a $100,000 award, the com- pany would be required to present significant evidence of commercialization in the form either of an agreement from a customer to buy the product or of match- ing funds. Because the firm's president was "horrified" by this stipulation, a meeting was arranged with Dr. Nelson who explained that one of the better ways of evalu- ating the commercial prospects for an SBIR award was gauging the project's ability to attract "other people' s money." Investment by the awardee firm itself was less significant than that by an outside company, because a third party is unlikely to invest in something that it thinks will be a loser. "My company presi- dent had worked all his life as a government contractor, and this did not make any sense to him," Mr. O'Hara recalled. "Looking at him and seeing that he just did not get it, I realized that I was in the wrong corporate culture." After observing at a trade show several months later that his boss was very interested in sessions at which scientific papers were presented "but showed no interest whatsoever in walking among the vendors and getting his hands dirty," he decided to leave the ~- rm. Within six weeks of forming Parallax to commercialize some of the technol- ogy that had been developed by his previous employer, Mr. O'Hara obtained a large purchase order for a product. He was not sure, however, whether the product could actually be produced; in fact, he had been told by staff at NASA and at the Lawrence Berkeley National Laboratory that production probably was not fea- sible. Using liquidated personal assets to operate Parallax, he achieved technical success in the ensuing months but was beginning to run out of money. At that point, his firm was saved by a Phase I SBIR award from BMDO, at the end of which it was able to build a prototype and to demonstrate that the technology "really worked." Commercialization and Phase II When the firm applied for a Phase II award, Dr. Nelson asked Parallax, as he had Mr. O'Hara's previous employer, to show significant evidence of its technology's commercial potential. A first indication was the purchase by a larger company of the firm with which Parallax had been collaborating, corroborated by a statement from the new owner that it had made the purchase solely because of its enthusiasm for the instrument that was being developed on the basis of Parallax' s technology. Then when this company put up matching funds, Parallax was able to get the Phase II award. Parallax has developed three products based on its technology, the first of which was introduced in the summer of 1997 and the second in September 1997; a third is scheduled for introduction in the spring

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PANEL IV 87 of 1998. Because the firm has not come to the end of its SBIR funding, it is planning the introduction of a fourth product as well. Mr. O'Hara stated he agreed with the premise that firms will not have much difficulty obtaining matching funds when they have good ideas that look like they are headed for commercial success; "I've given it one shot," he said, "and it's worked." He has received offers to buy not only the product that Parallax is on the verge of introducing but the firm itself. Still, he has reservations about the fact that the period that follows Phase II but precedes commercialization may turn out to be a long one. When it comes to the schedule for commercialization, larger organizations typically have a much longer time scale than a small, start-up company like Parallax, something Mr. O'Hara believes the funding agencies should take into account. ADVANCED TECHNOLOGY MATERIALS, INC. Gene Banucci President While remarking that Advanced Technology Materials, Inc. (ATMI), is a few years further down the road than Parallax, Dr. Banucci said that the story of his firm's success under SBIR compares with that of Mr. O'Hara's. After going into business in late 1986, ATMI won a SBIR grant from the Department of Energy (DoE); the product it yielded was promptly commercialized and, having booked almost $60 million in revenues to date, went on to become the largest single success in the history of DoE's SBIR program. ATMI's next SBIR award, from the Environmental Protection Agency, also resulted in prompt commercial- ization; total sales of the product developed from that award are approaching $100 million, while the product line based on it had brought in $30 million in revenues in the first six weeks of 1998. Dr. Banucci expects what he believes will be the program's first billion-dollar product to result from ATMI's subse- quent SBIRs: Separate awards from BMDO and NSF, both of which spanned Phase I and Phase II, helped with different aspects of the research. ATMI's Business ATMI went public in 1993; its market capitalization, initially at $35 million, now exceeds $600 million. What he called "a SBIR partnering strategy," which includes working with major corporations and integrating them into ATMI's busi- ness plan, has been the key to the firm's growth: "We took the intense pressure that Carl [Nelson] applied with regard to partnering and getting matching funds to heed because we desperately needed that money to grow the business." Because the firm is virtually certain to add 100 employees to its current work force of 400 by the end of 1998, this year is likely to be the last in which it will be eligible for

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88 THE SMALL BUSINESS INNOVATION AND RESEARCH PROGRAM the SBIR program. "By any measure," he said, "ATMI has been a SBIR success story, and we are very proud of saying that this program has been the catalyst for making ATMI a success in the public market." The company, which had revenues of around $102 million in 1997 and has facilities around the United States and in other countries as well, makes materials that go into a reactor to coat the silicon wafers from which semiconductors are made; it is these coatings that give each device its unique electrical and physical properties. ATMI has implemented a three-phase growth strategy, entering three niches: basic materials used in making semiconductors; environmental equip- ment used in managing those materials; and proprietary thinfilms, which it produces as a service business. ATMI's Technology The product developed from the research aided by the BMDO and NSF awards is designed to provide a safer and more environmentally benign alterna- tive for storing and transporting toxic, corrosive, or otherwise hazardous gases used in the semiconductor industry, which are generally packaged in pressurized cylinders. The new technology involves placing a solid absorbent in a standard gas cylinder, into which gas is then introduced; in the sealed cylinder, the gas is converted to a solid by its absorption on the solid substance, and it thus remains there without having to be kept under pressure. The absorbent is designed to release the gas under vacuum, which fits with the manufacturing environment of the semiconductor industry where most processes take place at reduced pressure. Thus, a vacuum pump draws the gas off the absorbent and out of the cylinder into the reactor, rather than pressure inside the cylinder expelling the gas. Not only are gases that are stored using ATMI' s technology safer to transport and handle, but the technology offers an improvement in productivity as well. Although the amount of gas that can be put into a conventional cylinder is dic- tated by the degree of pressure the cylinder walls can take, converting the gas to a solid form removes that limitation; and, in any case, a given amount of a sub- stance takes up far less space as a solid than as a gas. ATMI has been able to put between five and ten times as much gas in its cylinder as can be stored under high pressure in a cylinder of the same size, a result that promises to allow gas supply cylinders in semiconductor fabrication plants to be changed that many times less frequently. The potential for reducing downtime and lowering cost "means we can charge anything we want for that product," Dr. Banucci said. He expects earnings of the kind that made it possible for ATMI to return $6 million to the government last year in the form of taxes. The Role of SBIR He called SBIR "an absolutely terrific program" and urged the audience not

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PANEL IV 89 to lose sight of how well it is working in general, even if some fine tuning needs to take place, as it must in "any program that is going to be at peak form." Endors- ing Mr. O'Hara's view of the ease with which SBIR winners that have a unique technology can partner, he displayed a list of 13 major companies that have invested at least $1 million in a partnership with ATMI and stated that 85 percent of the money that has been put into the company has been related in some way to an SBIR award. To push SBIR recipients toward commercialization, the pro- gram could increase the size of awards to firms that have lined up partners willing to share costs. On the other hand, a mechanism should be sought that would put the "SBIR mills" out of business, and award winners must be held accountable for commercializing their ideas if the program is to achieve the goals advocated for it by Rep. Davis and Dr. Nelson. AMERICAN XTAL TECHNOLOGY Gary Young Vice President Placing his company between those of Mr. O'Hara and Dr. Banucci on the development continuum, Mr. Young said its business, making gallium arsenide substrates, is too small to interest either large companies such as AT&T which abandoned the technology American Xtal Technology (AXT) has developed or venture capitalists in the United States. In fact, the United States imports between 70 and 80 percent of its needs from Japan, which dominates the gallium arsenide substrate industry worldwide; because of the product's importance to electronics sectors downstream, large Japanese companies are willing to lose money year after year manufacturing gallium arsenide substrates. But while Sumitomo and Hitachi run what Mr. Young described as the equivalent of a "small DoD" to keep Japan' s supply base intact, the Pentagon itself is obligated under Title III to ensure the survival of a domestic supply base for gallium arsenide substrates as a strate- gically important material. AXT's Business Strategy Mr. Young, who like Mr. O'Hara, has liquidated personal assets to finance his company, sees product commercialization as the only path to a financial re- turn. AXT' s business strategy stresses high-quality output; providing the customer both with security of supply and the best bottom- line cost; diversifying the product mix;

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9o THE SMALL BUSINESS INNOVATION AND RESEARCH PROGRAM selling both in the U.S. domestic market, which accounts for 60 percent of its revenues, and in markets abroad; and supporting R&D. The Role of SBIR As a result of adhering to this strategy, he claimed, AXT has had a "very smooth ride" and enjoys a favorable reputation in its industry. And, with the help of SBIR, the company initially too small to qualify under Title III, which targets manufacturers already established in their industries has proved itself to the government by delivering on its promises and has grown large enough to be accepted under Title III. The capital demands resulting from AXT' s growth rate, which has averaged about 60 percent per year, have added to the pressure to commercialize. The firm plans to commercialize products developed through the two SBIR awards it has received: One was for gallium arsenide technology, the second was for indium phosphide technology, the latter described by Mr. Young as a little more expen- sive and, as a material, a little faster than gallium arsenide technology but other- wise similar. Alluding to comments made earlier that if SBIR supports only winners, it is being too conservative in its awards, he added that AXT's 100 percent success rate for commercialization makes it a "bad example." The market for gallium arsenide substrates, used in such telecommunications products as cellular phones and fiber-optic laser diodes, took off in 1995 thanks to an explosion in the popularity of the former product. At present, AXT has 230 employees and is the leading supplier of gallium arsenide substrates in the United States; its goal is to become world leader in 1998 or 1999. In the third quarter of 1996, it built a 50,000-square-foot production facility on 4.6 acres of land it had purchased the previous year. A 30,000-square-foot expansion is to be completed in either February or March 1998, and the company is looking to open another site, in the range of 50,000-100,000 square feet, in 1999. Profitable for 28 con- secutive quarters, AXT has paid more than $8 million in taxes, showing its pro- prietors to be either "good citizens or bad tax planners." The company recently completed filings with the Securities and Exchange Commission. DISCUSSION The Need for Cooperation Terry Bibbens of the SBA began by praising the National Research Council for convening members of the academic, small business, and SBIR communities and by urging the various communities to work together: "When the Army went up and battled the Navy for appropriations and vice versa," he recalled, "neither one of them got funding." Then, explaining that it is the job of SBA's Office of

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PANEL IV 91 Advocacy, where he serves as Entrepreneur-in-Residence, to ensure that federal rules and regulations have no unfair negative impact on small business, he argued that obliging SBIR award recipients to put up matching funds would in fact be ~ . unfair. Matching requirements should be attached to SBIR awards only if identical requirements are placed on the remaining 97.5 percent of federal R&D funds, which generally go to larger companies and universities. "Any singling out of small business to match funds for the research agenda of this nation is unfair and unreasonable and penalizes small business," he stated. Pointing out that during the current economic recovery, smallbusiness has created 12 million new jobs while 2 million jobs have been lost by big business, he warned policymakers not to "put hurdles in front of the small business community." Furthermore, imposing matching requirements on SBIR awards would be unfair in light of the venture-capital industry's aversion to small deals and of the absence of a model whereby small firms can line up matching funds from other sources. Fewer than 3,000 companies annually receive investment money from the U.S. venture community, including from Small Business Investment Corpo- ration, and the average size of those investments is now approaching $13 million. "The massive amount of funds that come into the venture community does not even apply to the SBIR community," stated Mr. Bibbens, adding that "SBIR com- panies are not looking for $13 million, they are looking for a million, a half- million, maybe two million [dollars]." Applauding the DoD's Jon Baron for the Fast Track pilot program, he expressed the need for a vehicle that would draw investors to companies of the size that apply for SBIR awards. Focus on Commercialization Responding to Mr. Bibbens's first point, Dr. Nelson placed SBIR moneys in a different category from the other 97.5 percent of the federal R&D budget on the grounds that the "objective of commercialization" stated in the law creating SBIR is "unique for R&D in the government." Because the amount of money going to the small business community is set under the law, small firms are not competing with large institutions in any way. Moreover, he pointed out, he had never required matching funds; rather, he had told proposers that he would make the existence of matching funds "a live, competitive factor" in selecting Phase II awards. But although never a requirement, matching funds, often on a dollar-for- dollar basis, started showing up in Phase II proposals beginning around 1995 because the proposing companies, realizing that commercialization had been made a criterion, "could not wait to go out and prove their commercialization merit by bringing in commercial partners." Only about 20 percent of this matching fund came as money from venture- capital firms or angel investors; the remaining 80 percent was from third-party

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92 THE SMALL BUSINESS INNOVATION AND RESEARCH PROGRAM firms, and a large part of that was in-kind aid provided within their own compa- nies in some way that would advance the technology's position in the market- place. There was no contractual requirement regarding what had to be done by the SBIR winner's partner company; marketing, testing, and R&D were all acceptable. "My only requirement," said Dr. Nelson, "was that the contracting officer saw that the money was being spent in furtherance of the technology."