Startups Risk Losing Federal Grants –

Some of our nation’s most innovative companies are unfairly punished for seeking and receiving venture funding. The culprit: the recent, unprecedented enforcement of a size criterion for Small Business Innovation Research (SBIR) grant awards at the National Institutes of Health (NIH).

In the last few months, several venture-backed companies have had grant awards revoked after the Small Business Administration (SBA) determined that these businesses were not “at least 51% owned and controlled by one or more individuals.”

Under the SBA determination, venture-backed companies that would otherwise be classified as a small business cannot qualify as a small business because venture capital firms are not considered “individuals.”

At a time when government-supported research is an increasingly important income, the venture community and its portfolio companies, as well as the successful track record of the SBIR program, are at great risk. Enforcement of this size criterion runs counter to the intent of the SBIR program, and its enforcement will deeply harm the thriving entrepreneurial community.

A quick review of 2003 NIH grants awarded to California companies shows that the problem has the potential to cause significant harm. Of the 134 grants awarded so far this year, more than 30 have gone to companies that are or were venture-backed. Nine of those companies are now public. Of the remaining companies where company valuation is known, none can qualify for awards using the 51% ownership criteria.

Given typical valuations of companies even after an initial round of funding, it is safe to say that the other companies with unknown company valuations also do not qualify for award.

The situation is similar when reviewing Massachusetts venture-backed companies. So far in 2003, 16 venture-backed Massachusetts companies have received NIH grants, representing more than 16% of total awards to Massachusetts companies. If you exclude now public companies, there are still 12 venture-backed companies that would probably be excluded from an award if the 51% language were enforced.

The size criteria has the potential to be even more damaging to companies in the Midwest, where federal grants are a more integral part of an investing and growth strategy because venture rounds are smaller and require broader syndication.

In essence, the NIH is saying that if a company is venture-backed, they aren’t interested in supporting its research and development. This is counterintuitive to the entire process. The venture community and America’s research institutions, through the SBIR program, have always aimed to support the same group of companies that have the best potential to produce the most innovative products. And the size criteria is inconsistent with past NIH practice, which has always valued affirmations of support from venture firms in the grant application process.

All of this makes this new stance even more troubling.

In a typical venture portfolio, at least half of the companies, and probably the vast majority, cannot qualify under the size criterion should they seek federal grants. If enforcement becomes consistent throughout the SBIR program, it will put all grants at risk, including those from the Department of Defense, the Department of Energy, and the National Science Foundation.

The National Venture Capital Association (NVCA) addressed this issue in a letter to the SBA during a comment period about a remotely related change to the size criteria of wholly owned subsidiaries of corporations. To the best of anyone’s knowledge, it is these companies that the SBA is attempting to exclude from SBIR grant award, not our portfolio companies. But to accomplish this, the NIH has adopted a strict interpretation of the 51% criteria and has not differentiated between VC ownership and corporate ownership. Unfortunately, despite the clear differences between a VC-backed and a corporate-backed company, the SBA’s attempt to address corporate issue will not alleviate the problem.

NVCA has taken these concerns to the U.S. Congress and they are working with the venture community to address the problem. But your representatives and senators need to hear from you. I urge you to contact the NVCA and become involved in seeking a solution to this problem.

Ryan M. Schwarz is a principal with The Carlyle Group, where he is responsible for all health care investing. His particular focus is on medical devices, medical technology and health care information technology. Schwarz is based in Washington, D.C.