Congress must fix flawed SBA policies

On Sept. 6, I testified on behalf of the National Venture Capital Association in front of the House of Representatives Committee on Small Business. The purpose of my testimony was to support the 2007 Small Business Investment Expansion Act of 2007. Over the last several years, the NVCA has been working to improve the relationship between the Small Business Administration and venture-backed companies. Recent SBA interpretations have suggested that there remains a significant disconnect regarding the need for a public/private partnership relating to small business growth. The proposed legislation takes positive steps toward furthering our efforts. A redacted version of my testimony is below.

Thank you for the opportunity to share with you today the challenges that our small venture-backed businesses have faced as it relates to current SBA policies and why we believe the Small Business Investment Expansion Act of 2007 is a positive step towards fostering the type of private/public partnership that will allow the United States to sustain its economic leadership for years to come.

Need for true partnership

To date much of the Congressional debate around SBA’s policies and interpretations have focused on the details and nuances of each particular issue. On behalf of the venture capital community, we think it is important to take a step back and for you, the Congress, to ask what can be done to best support the creation and development of small businesses in the United States. We believe partnerships between government and the venture capital community have and will continue to be one of these winning strategies.

In 2006, venture-backed companies accounted for 10.1 million jobs and $2.3 trillion in U.S. revenue. Companies that were once small venture-backed businesses include Google, Genentech, Starbucks, Microsoft and Federal Express. Today, I am here on behalf of the next Google or Genentech that is currently being funded by a venture capital firm and is significantly disadvantaged by current SBA policies.

Since 2001, a change in the interpretation of policy at the Small Business Administration (SBA) has run in direct opposition to the premise that venture-backed businesses are one of the most promising vehicles driving U.S. economic leadership and should be supported wherever possible. Specifically, we are troubled by the SBA’s recent interpretation of its affiliation rule in determining whether a company meets the small business criteria.

Bad experience

Under the existing affiliation requirements, a business concern can have no more than 500 employees, including its affiliates to qualify as a small business. Under this requirement, most venture-backed businesses would meet the criteria. However, the SBA has recently applied a formula that sweeps in the venture capital firm AND the employees from every company in which the venture capital firm invests when considering a venture-backed company for small business classification. Unfortunately, I have been involved in one of these instances over the past year.

SBA notified the company that it had determined that Domain Associates controls the company and requested information with respect to Domain’s ownership in ALL of our other unrelated portfolio companies.”

Bob More, Partner, Domain Associates

Approximately nine months ago, one of my firm’s portfolio companies filed a new drug application (NDA) with the Food and Drug Administration and requested a small business waiver for the FDA’s application fee. The fee was approximately $900,000. The FDA requested that the SBA conduct a formal “size determination” with respect to the company’s eligibility. The company filed the appropriate paperwork, which showed that during the three-year period prior to the filing of the NDA, it averaged 7.25 employees.

A month later, the SBA notified the company that it had determined that Domain Associates controls the company and requested information with respect to Domain’s ownership in ALL of our other unrelated portfolio companies. If Domain was deemed to control any of the other companies, they would be deemed to be “affiliates” of this company and their employees counted in the total.

We informed the SBA that Domain only has the right to elect one out of six directors and neither Domain nor any of the three other venture capital firms invested have the ability to exercise control over the company. In response to this explanation, the size specialist at the SBA responded by saying: “That may be true, but the SBA does not deal in the real world.”

In order not to jeopardize its NDA, the company paid the $900,000 filing fee to the FDA and has now requested a refund from the SBA. This is a sum of money that would otherwise be directed toward the company’s growth. Last week, the company was advised by the SBA that, after more than seven months, the SBA is still working on the matter.

It is difficult to understand how the SBA justifies its position when it directly contradicts language in the Small Business Investment Act, which seems to address this very issue. Ownership by a venture capital firm should not trigger the Affiliation Rule for programs that were created under the SBIA.

Anti-VC perception

It appears that the SBA has the gross misperception that a small business that receives venture backing should not be considered a “small business.” But our industry is focused on building companies that will commercialize a product or service. We typically enter an investment when the early stage research has been completed. Therefore, a small business must leverage other sources of financing to bring research to the stage where it can be commercialized by a venture capitalist.

Often a venture capitalist is funding one product while the company is building a pipeline of new products through basic research. Without this SBA support, many technologies would linger “on the shelf” because they would not reach the stage where they could be brought to a venture capitalist.

The Small Business Investment Expansion Act of 2007 is a positive step towards fostering the type of private/public partnership that will allow the United States to sustain its economic leadership for years to come.”

Bob More, Partner, Domain Associates

Intuitively, it would seem that the SBA would want to fund venture-backed companies because these companies have already been vetted by professionals who think highly enough of the management team to invest. Unfortunately, this is not the case. The current interpretation by the SBA could be likened to a situation in which the NIH would refrain from funding any project at a well-endowed academic institution because it already has money behind it.

Clearly, this is not the case with the NIH, because the reasoning behind such a premise is fatally flawed. So, too, is the SBA interpretation of venture-backed companies. These companies have just as great a need as non-venture-backed entities—and are probably better positioned to succeed. So while Congress and the Administration are doing all that they can to promote job growth and innovation, the SBA’s policies have ironically been stifling it.

This issue of the SBA discriminating against venture-backed companies is not limited to the affiliation rule. We are facing similar issues when applying for Small Business Innovative Research (SBIR) grants. Here the SBA has used VC ownership as a reason not to grant basic research funds to our companies that have very promising projects waiting for funding. Though not the focus of today’s discussion, it is worthy of mentioning because it demonstrates a pattern of animosity of the SBA toward venture-backed companies and it, too, needs to be fixed.

NVCA supports the Small Business Investment Expansion Act, specifically Title V, which will resolve the SBA’s affiliation issue and which will clarify the SBA’s affiliation rules by ensuring that businesses with venture capital investment are not penalized. It will also put in place proper safeguards to ensure that this provision cannot be exploited by large businesses by specifically defining a venture capital operating company.

Over the years, current and past Administrations have focused on marshalling economic resources to help spur innovation and develop programs that would provide incentives to foster public/private partnerships to further the country’s economic goals. The American Competitiveness Initiatives, the Department of Defense-Defense Venture Catalyst Initiative, In-Q-Tel and DARPA (Defense Advanced Research Projects Agency) are a few examples of these types of programs. But the SBA’s policies have and will continue to have a chilling affect on the federal government’s ability to leverage the most promising small businesses in the country.

No other asset class supports the premise more that small businesses are the lifeblood of the U.S. economy than venture capital. We are not sure what world the SBA operates in, but in our world all of these small businesses should have access to the same benefits. We are confident that the proposed legislation is a positive step in keeping us all in the real world and assuring that the United States maintains its competitive edge by supporting small businesses of all kinds.

Bob More is a partner at Domain Associates in San Diego, California. He is also a member of the National Venture Capital Association. He can be reached at more@domainvc.com.