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Should Venture-Backed Biotechs Be Shut Out of SBIRs?

The biotech industry’s has been putting on pressure to let biotech companies owned by venture capitalists qualify for federal small-business grants. Through the SBIR program, 2.5 percent of the outside research and development budgets of 10 federal agencies is set aside for small businesses, defined by SBA as those with fewer than 500 employees.

Specifically, the NIH hands out about $600 million per year under the Small Business Innovation Research (SBIR) program [1], which is overseen by the Small Business Administration. Nine other agencies award another $1.4 billion combined.

The program has three phases. Phase I contracts are valued up to $100,000 (different at each agency) and are awarded for research efforts lasting approximately six months. Each project addresses a topic area identified in an agency solicitation. Phase I awards help determine the feasibility of a new technology. The required proposal to win a Phase I SBIR contract is kept short and simple to help encourage participation. It is limited to 25 pages and must comply with explicit, easy-to-follow instructions spelled out in the solicitation.

Phase II contracts are only awarded to successful Phase I contract winners and are valued up to $750,000 (again, different at each agency). Awards for Phase II contracts are based on Phase l results and the scientific and technical merit of the Phase II proposal. Besides the scientific quality of the Phase II proposal, the potential of the concept for commercial applications is given careful consideration.

Phase III involves private sector or federal agency funding (outside of the SBIR program) to commercialize the technology.

Now, the SBA will no longer give these grants to companies that are majority owned (51 percent) by venture capitalists. The way the rules are constructed, a venture capital firm can have up to 49 percent ownership in a venture awarded an SBIR grant. A venture group can have a majority stake in a biotech if the venture firm is 51 percent owned by individuals and has no more than 500 employees.

The irony of this whole thing is that the companies that are successful — and thus, able to attract venture capital — are then barred from getting additional SBIR grants. But problems came up in a gray area common for biotech start-ups: What happens when several venture capitalists have minority stakes, say 15 to 20 percent each, that collectively form a majority stake?

This has a lot of ramifications in the biotech world since many startup and emerging biotech firms rely on SBIR grants for seed money to fund early stage research. Apparently, most biotech companies raise between $5 million and $15 million in their first round of venture funding, an amount that usually results in venture capitalists owning more than half the company. They typically require $800 million and 10 to 15 years of research and risky clinical trials in many cases to market one product, according to BIO statistics.

Biotechnology Industry Organization (BIO) says this has resulted in a dumbing-down of the quality of science in grant applications from small biotechs. CEO James C. Greenwood wrote in an op-ed article in the July 13 Washington Times that many small biotech and other technology companies are “victims” of the SBA’s “new interpretation” of venture funding in applicants for SBIR grants.

Not all small biotechs agree this is a problem, though. On the flip-side, allowing venture-backed companies to get the SBA money naturally siphons off dollars that could have gone to emerging biotechnology companies without another source of revenue. If the purpose of the grants is to get companies to being venture-eligible, then restricting the money seems to make sense.

The SBA is currently reviewing written comments from dozens of companies, associations such as BIO and educational institutions, and from a series of hearings. The agency is due to report on any possible changes to grant eligibility rules by the end of the year.

At least two bills on the issue have been introduced in Congress. Rep. Sam Graves (R-Mo.) introduced the Save America’s Bio Technology Innovative Research Act of 2005, H.R. 2943, which would allow companies that get majority funding from venture capital to be eligible for SBA programs. Sen. Kit Bond (R-Mo.) has introduced similar legislation. The bills have at least four Democratic co-sponsors.

For more information, see here [2] and here [3].