7.1. MAIN FINDINGS

A. A limited number of venture-funded firms appear to have been excluded as a direct result of the SBA ruling.¹

• Firms that either received more than one round of venture funding, or received at least $5 million in venture funding are considered “venture-controlled” for purposes of analyzing the impact of the SBA ruling.² The 183 firms identified as meeting one or both of the criteria constitute our pool of potentially excluded companies. They constitute 11.9 percent of all the 1,536 NIH Phase II winners 1992–2002 reported by SBA.³
• Altogether, using our criteria, a minimum of 4.1 percent (63 firms) of participating firms have been excluded because of the SBA ruling; a further 4.5 percent (69 firms) would have been excluded by the ruling, but were also excluded on other grounds. A further 3.3 percent had become publicly traded companies, which are also likely to be excluded.

• Not all firms receiving venture funding are excluded as a result of the ruling: Current levels of venture funding for 3.2 percent of all Phase II recipients were insufficient meet the proxy indicators developed for this study that reflected breach of the SBA eligibility rules.
• In short, between 4.1 percent and 11.9 percent of firms that won SBIR Phase II awards from NIH between 1992 and 2002 are excluded from the program as a result of the SBA ruling.⁴

B. The ruling seems to disproportionately affect firms with demonstrated potential for significant commercialization.

• Of the top 200 Phase II winners at NIH, 43 (21.5 percent) received sufficient VC funding or VC rounds of funding to meet the criteria for VC control and are therefore excludable from the NIH SBIR program under the SBA ruling. This compares with 148 out of 1,336 (11.1 percent) for the remaining firms outside the top 200 Phase II award winners.⁵
• The evidence suggests that the impact of the ruling falls most heavily on the limited number of firms that have been selected both by NIH for their promising technologies and by venture investors for their commercial potential.

C. SBIR firms—with or without venture funding—commercialize in significant numbers.⁶ 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.

• Non-venture-backed firms actually reach the market more frequently. Specifically, SBIR projects at venture-funded firms are somewhat less likely to reach the market than non-venture-funded firms—38 percent do so, compared with 55 percent for other SBIR firms.⁷
• It is important to note that in both cases, this is positive news for the NIH SBIR program; non-venture-funded and venture-funded firms both reach the market in significant proportions.
• Among the firms that reach the market, projects at firms that are venture-funded are much more likely to generate significant sales from their SBIR-funded projects than are firms that are not venture-funded. Evidence from Hoover’s data-base indicates that about 80 percent of non-venture-funded firms in existence as of 2006 (that received SBIR Phase II funds from NIH) had less than $5 million in annual revenues, with 6 percent having annual revenues of $50 million or more. By contrast, only 40 percent of venture-funded firms have less than $5 million in annual revenues, and 18 percent generated at least $50 million.⁸
• Venture-funded firms generated considerably more annual revenues than non-venture-funded firms. According to Hoover’s database, median revenues for reporting venture-funded firms were $9.3 million, and for non-venture-funded firms were $1.0 million. It is also true that a smaller percentage of venture-funded firms were currently reporting revenue data.⁹

D. At NIH, SBIR awards with venture-funding received marginally more patents per project than did the non-venture-funded firms.¹⁰

• It is noteworthy that between 35 and 45 percent of all companies with SBIR grants—whether venture-funded or not—contribute to the creation of patentable knowledge.
• With regards to the relative difference, in some cases, this may be because venture-funded firms have additional resources to expend on protecting their intellectual property through patenting. In addition, some venture capital firms may provide sources of expertise on patenting.

E. A survey of non-participants indicates that the SBA ruling has played a limited role in the decisions of small firms not to participate in the NIH SBIR program.

• NRC surveyed firms and principal investigators who applied for NIH funding during the period leading up to the 2002 SBA ruling, but who have not since applied for NIH SBIR funding.¹¹
• NIH identified 3,913 such non-participant firms, of which 2,051 had valid email addresses. The NRC survey sent to these addresses yielded 386 responses, or an 18.5 percent response rate. Of these 386, some 49 firms were found to have in fact received further funding. A further 87 indicated that they expect to apply for SBIR awards in the future.
• The remaining 269 respondents were asked why their firms were no longer applying for SBIR awards. The three most frequent reasons for not applying were the level of competition, concerns about the selection mechanism, and funding delays. Venture ownership (along with foreign ownership and shifts to foreign ownership) was one of the three lowest scoring reasons for leaving the program.
• Because being excluded is itself a sufficient condition for non-participation, we also asked respondents to identify a reason for not applying to the program.¹² 3.7 percent of respondents indicated that ownership exclusions arising from the 2002 SBA ruling was a reason for not applying; 2.5 percent reported that it was the single primary reason for not applying—a figure somewhat lower than the NRC’s estimate for affected companies overall.

F. Recognizing that the number of affected firms is small, it is the judgment of the Committee that restricting access to SBIR funding to firms that benefit from venture investments would risk disproportionately affecting some of the most 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, especially in the biomedical area.

• Small businesses use SBIR awards and venture funding in complementary ways to help them bring new ideas to the market. Small business entrepreneurs note that innovative small businesses often support their primary line of research and development with non-SBIR sources, while SBIR helps to advance additional lines of research.¹³ Firms interviewed for the NRC SBIR study also indicate that the kind of research funded by SBIR has sometimes been closely combined with venture funding to support the research on which to build, over time, a highly successful company.¹⁴
• Data gathered for this study indicate that the number of major SBIR successes would be reduced under the 2002 eligibility requirements, and that the average amount of commercialization per project would decrease.

7.2. RECOMMENDATIONS

A. Based on the Committee’s analysis of the impact of restricting venture funding on the NIH SBIR program, and its experience in the larger evaluation of the SBIR program 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 commercial potential to compete for SBIR funding.¹⁵

• In its comprehensive assessment of SBIR in the period prior to the 2002 SBA directive, the Committee found the program to be “sound in concept and effective in practice.”¹⁶
• Although the evidence is not definitive, the implementation of the SBA ruling appears to be negatively affecting current participation by firms and the long term commercialization potential of the NIH SBIR program.¹⁷
• There is no evidence that non-venture-funded firms have been crowded out by venture-funded firms. Should this occur, SBIR managers can and should address it, as appropriate.

B. In its recent assessment of SBIR, the Committee found that the concept of the program is sound and recommended that the basic program structure of SBIR be preserved. Accordingly, the Committee recommends that SBA and the agencies should maintain an open competition that is based on scientific quality and commercial potential.¹⁸

• Scientific quality and responsiveness to agency topic solicitations are the primary criteria for selecting SBIR funding. SBA and the participating departments and agencies should maintain an open, science-based competition for the program’s resources and rely on the judgment of the agency program managers and the established selection procedures of the SBIR program.
• Given the small number involved, allowing a percentage of majority-owned applicants to participate might be an effective solution. At the same time, the use of this type of solution should be sharply limited, insofar as dividing the program up with quotas runs the risk of initiating a Balkanization of the program that would undermine the open competition that underpins the program’s effectiveness.¹⁹
• By making some innovative small businesses ineligible for SBIR, the ability of the program to address the program’s legislative goals would appear to be reduced, although it should again be noted that the absolute number of firms with venture funding does not appear to be large.

C. The Committee reaffirms the recommendation made in its overall assessment of SBIR that SBA should maintain the commendable program flexibility it has exercised in the past.²⁰

• Continue to rely on agency managers’ judgment, experience, and understanding of mission needs to effectively administer the SBIR program.
• Ongoing assessment of this and other issues would be beneficial to program management. The National Research Council’s recent assessment of the operation of SBIR at the five agencies accounting for most of the program calls for regular internal and external evaluation of SBIR to assess and reinforce or change, as necessary, agency practices and experimentation.²¹

D. NIH should conduct follow up assessments of its SBIR program, including the impact of venture capital participation and eligibility requirements on program involvement and outcomes.

• The rapid growth of the NIH SBIR program, and the subsequent sharp decline in applications call for follow-up analysis to this report. NIH should use the data for 1992–2002, used in this study as a baseline for subsequent analysis.
• A second snapshot: It would be especially useful to assess the subsequent behavior of the largest winners at NIH as their departure from the SBIR program would signal a significant and potentially important shift in the program’s effectiveness.

Footnotes

1

The estimates below are based on information from the VentureSource database, the NRC Non-participant Survey, and NIH data.

2

See Figure 3-1.

3

See Table 3-4.

4

See Table 3-4

5

See Table 2-1.

6

The high-risk nature of investing in early-stage technology means that the SBIR program must be held to an appropriate standard when it is evaluated. While venture capitalists are a referent group, they are not directly comparable insofar as the bulk of venture capital investments occur in the later stages of firm development. SBIR awards often occur earlier in the technology development cycle than where venture funds normally invest. Nonetheless, returns on venture funding tend to show the same high skew that characterizes commercial returns on the SBIR awards. See John H. Cochrane, “The Risk and Return of Venture Capital,” Journal of Financial Economics, 75(1):3–52, 2005. Drawing on the VentureOne database, Cochrane plots a histogram of net venture capital returns on investments that “shows an extraordinary skewness of returns. Most returns are modest, but there is a long right tail of extraordinary good returns. 15 percent of the firms that go public or are acquired give a return greater than 1,000 percent! It is also interesting how many modest returns there are. About 15 percent of returns are less than 0, and 35 percent are less than 100 percent. An IPO or acquisition is not a guarantee of a huge return. In fact, the modal or ‘most probable’ outcome is about a 25 percent return.” See also Paul A. Gompers and Josh Lerner, “Risk and Reward in Private Equity Investments: The Challenge of Performance Assessment,” Journal of Private Equity, 1(Winter):5–12, 1977. Steven D. Carden and Olive Darragh, “A Halo for Angel Investors,” The McKinsey Quarterly, 1, 2004, also show a similar skew in the distribution of returns for venture capital portfolios.

7

See Figure 6-1.

8

See Figure 6-3.

9

In some cases, this may be because venture-funded firms had been acquired and hence were no long independent reporting entities, but this is not certain.

10

See Table 6-5.

11

See Table 5-1.

12

See Table 5-2.

13

See, for example, testimony by Douglas Doerfler of Maxcyte, Inc., before the House Committee on Small Business, January 29, 2008.

14

See, for example, case studies of Illumina and Neurocrine in Appendix D of National Research Council, An Assessment of the SBIR Program at the National Institutes of Health, Charles W. Wessner, ed., Washington, DC: The National Academies Press, 2009.

15

The advantages of an SBIR award include not only the undiluted equity that the grant represents but also the fact that awardees retain intellectual property rights to their product. Perhaps most important, the rigorous reviews of technological and commercial potential that are a part of the award process confer a certification or “halo effect” on the company that in turn is a positive signal to the private capital markets. For an analytical discussion of the halo effect, see Maryann Feldman and Maryellen Kelley, “Leveraging Research and Development: The Impact of the Advanced Technology Program,” in National Research Council, The Advanced Technology Program: Assessing Outcomes, Charles W. Wessner, ed., Washington, DC: National Academy Press, 2001. For a discussion of the certification effect, see Josh Lerner, “Public Venture Capital,” in National Research Council, The Small Business Innovation Research Program: Challenges and Opportunities, Charles W. Wessner, ed., Washington, DC: National Academy Press, 1999.

16

National Research Council, An Assessment of the SBIR Program, Charles W. Wessner, ed., Washington, DC: The National Academies Press, 2008.

17

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.

18

In its cross-agency assessment of SBIR, an NRC Committee recommended that the basic program structure of SBIR be preserved, even as it called for more program experimentation and evaluation to help the program adapt to changing mission needs and technological opportunities. See, in particular recommendations G and H in Chapter 2 of National Research Council, An Assessment of the SBIR Program, op. cit. In particular, Recommendation G rejects the idea of bypassing Phase I for firms that are ready to apply for a Phase II award. Such a bypass would differentially advantage firms that have other sources of early-stage funding.

19

One version of the pending legislation in Congress would allow the National Institutes of Health to award up to 18 percent of its SBIR dollars to venture capital-funded firms. The other ten agencies that participate in the SBIR program could award up to 8 percent of their SBIR dollars to these types of companies.

20

The first recommendation of the NRC assessment of the SBIR emphasizes the need to preserve program flexibility. It states that “Agencies, SBA, and the Congress should seek to ensure that any program adjustments made should not reduce the program’s flexibility.” See National Research Council, An Assessment of the SBIR Program, op. cit., p. 73. This flexibility is an important element in the success of the SBIR program. Although each agency’s SBIR program shares a common three-phase structure, the SBIR concept is interpreted uniquely at each agency. This flexibility is a positive attribute in that it permits each agency to adapt its SBIR program to the agency’s particular mission, scale, and working culture.

21

The second recommendation of the NRC assessment of SBIR states that “Regular evaluations are needed.” See National Research Council, An Assessment of the SBIR Program, op. cit.