The Small Business Innovation Research (SBIR) program implements the Small Business Innovation Development Act, which requires certain federal departments to reserve 2.5% of their research and research and development dollars for award to small businesses.2 Eleven federal agencies have SBIR programs, led by the Department of Defense and the National Institutes of Health, and in FY 2002 those eleven agencies made approximately 5,0000 SBIR grant awards, totaling in excess of $1.5 billion. Each agency program operates under governing regulations and a policy directive issued by the U.S. Small Business Administration (SBA).3
This article highlights a recent SBA amendment to the SBIR regulations that relaxes ownership requirements for SBIR awardees. The regulatory change will expand the universe of firms eligible for the SBIR program, provide SBIR participants new flexibility in structuring corporate participation in the SBIR program, and should provide new opportunities for venture capital firms to invest in SBIR participants.
The SBA.s regulatory change is contained in a final rule, effective January 3, 2005, that revised 13 C.F.R. § 121.702, the SBA regulation governing ownership and control of SBIR awardees.4 Although the revision changed Section 121.702 in several respects, the principal change was to add to the list of SBIR-eligible .small business concerns. (SBCs) those SBCs that are owned and controlled by a single parent where the parent also meets the SBA.s ownership and control requirements for SBIR awardees.5 The change will permit business concerns that meet the ownership requirements of Section 121.702 to use subsidiaries to apply for SBIR grants, and will permit similarly structured venture capital firms to own SBIR-eligible subsidiaries. Subsidiaries as SBIR Awardees
To appreciate the significance of the recent SBA change requires an understanding the Section 121.702 ownership requirements. Section 121.702(a) has long contained a restrictive ownership provision governing SBC eligibility for SBIR grants, namely, to be eligible for an SBIR grant, the SBC must be at least 51% owned and controlled by individual U.S. citizens or permanent resident aliens. Under this provision, majority ownership and control of the SBC must be in the hands of natural persons, and should non-individuals (i.e., entities such as corporations or partnerships) hold more than 49% ownership/control of an SBC, the SBC is not eligible for award of SBIR grants.
Consequently, prior to the change in the December 3rd final rule, Section 121.702 effectively precluded a corporation or partnership, even though it met the Section 121.702(a) ownership test, from using a subsidiary as an SBIR applicant because the subsidiary would have been owned/controlled by a non-individual, i.e., the parent corporation or partnership. As a practical matter, Section 121.702(a) prevented an otherwise eligible SBC from segregating its SBIR research projects, with their unique SBIR rules, from the rest of the SBC.s work, through use of a separate subsidiary just for SBIR research. That the parent met the requirements of Section 121.702(a) (by being 51% owned/controlled by natural persons who met the U.S. citizen requirement), and that the subsidiary, together with the parent, met the applicable 500 employee size standard, made no difference. In fact, previous attempts to avoid the natural person requirement of Section 121.702(a) by arguing that the terms .individuals. or .U.S. citizen. encompassed business had been fought by the SBA and rejected by the SBA.s Office of Hearings and Appeals.6
Turning now to the December 3rd final rule, the SBA recognized, at long last, that the Section 121.702 ownership rule was needlessly restrictive and only served to prevent otherwise qualified firms from participating in the SBIR program.7 To correct the problem, at least in part, the SBA decided to expand the eligible pool of SBCs by adding an ownership class consisting of those entities that are 51% owned/controlled by no more than one other firm, provided that the parent firm itself meets the SBIR natural person/U.S. citizenship test.8 The SBA anticipates that small research and development firms will be most benefited by the change
Small R &D concerns that will become eligible for SBIR Program awards are the primary beneficiaries of this rule. Specifically, benefits will flow to concerns that were ineligible for SBIR awards solely because they were owned and controlled by other concerns, rather than natural persons. In addition, companies owned and controlled by SBIR participants, which were previously ineligible to participate in the SBIR Program, are now eligible.9
Notably, the SBA had originally proposed that the parent hold 100% ownership/control in the subsidiary, but decided after considering public comment on the proposal that 51% would be sufficient to preserve SBIR qualifying status.10 A single parent firm, however, must hold the entire 51% interest to meet the requirements of Section 121.702(a)(1)(ii).11 On the other hand, there is no limit to the number of SBIR subsidiaries in which parent concern may hold 51% ownership/control, although the parent entity (including all subsidiaries and other affiliates) is subject to the overall 500-employee size standard applicable to the SBIR program contained in Section 121.702(b).12
The SBA anticipates that the change to Section 121.702(a) will expand the number of SBIR-eligible firms by 50 to 100 firms.13 Besides increasing the number of SBIR-eligible firms, the ability to use a subsidiary to conduct SBIR-funded research will provide all SBIR program participants, current and future, with enhanced freedom to use a subsidiary for SBIR program activities and thereby more readily tailor their accounting systems, employee compensation agreements and benefit packages, intellectual property licenses, etc., specifically for the SBIR program.
The final rule should also pave the way for substantially greater participation by venture capital companies (VCCs) in the SBIR program. In the past, VCCs have found the SBA.s 51% natural person ownership/control requirement to be a major obstacle to investment in SBIR participants because it prevented venture capital entities organized as corporations or partnerships from taking an interest greater than 49% in an SBIR awardee. Now, as expressly permitted by Section 121.702(a)(1)(ii), a VCC owned by at least 51% natural persons (who are U.S. citizens or permanent residents) will be able to hold the controlling interest in an SBIR awardee. Indeed, this very outcome was specifically anticipated by the SBA:
The SBA notes that this final rule makes no distinction between a VCC and other for-profit entities. This rule allows a VCC to own and control an SBIR awardee, as long as the VCC is itself at least 51% owned and controlled by U.S. citizens and permanent resident aliens and the SBIR awardee, together with its affiliates, meets the 500-employee size standard.14
Section 121.702(a)(1)(ii) would also permit a VCC to take a controlling interest in multiple SBIR firms, because, as noted above, Section 121.702(a)(1)(ii) places no limit on the number of SBIR subsidiaries that a .business concern. may own/control (subject to the 500-employee SBIR size standard in Section 121.702(b)).
Other Changes to Section 121.702
The December 3rd final rule also added new provisions, Section 121.702(a)(1)(iii) concerning joint ventures, and Section 121.702 (a)(2) and (3) concerning employee stock ownership plans (ESOPs) and trusts. The new joint venture provision, drawn from an identical provision in the SBA.s SBIR Policy Directive, authorizes SBIR awards to joint ventures provided each member of the joint venture meets the 51% natural person ownership/control/U.S. citizen requirements of Section 121.702(a)(1)(i) or (a)(1)(ii). The new provisions on ESOPs and trusts .clarifies. the SBA.s position that ESOPs and trusts may own SBIR awardees. For ESOPs, each plan member and trustee will be considered an owner. For trusts, each beneficiary and trustee will be considered an owner. The final rule also amended the introductory language of Section 121.702 (by deleting the term .to compete.) to clarify that an SBIR participant need only meet the eligibility requirements at time of SBIR award, not when the SBIR application is submitted to the federal agency for consideration.15
Footnotes
1. David Ralston and Stephen Maebius are partners with the law firm of Foley & Lardner LLP, resident in the Washington, D.C. office. Mr. Ralston is the co-chair of Foley.s litigation department in the Washington office; his practice focuses on federal government contracts, grants and litigation. Mr. Maebius is chair of the Nanotechnology Industry Team; his practice focuses on biotechnology and pharmaceutical intellectual property issues. Copyrighted by Foley & Lardner LLP. 2. The Small Business Innovation Development Act, enacted in 1982, is Section 9(e)(4) of the Small Business Act and is codified at 15 U.S.C. § 638(e)(4) (2004). It was amended (and the SBIR program re-authorized until 2008) by the Small Business Innovation Research Program Reauthorization Act of 2000, P.L. 106-554. An agency is required to establish an SBIR program if its annual budget for external research or research and development exceeds $100 million.
3. The SBA.s SBIR regulations are published in the Code of Federal Regulations at 13 C.F.R. §§ 121.701-121.705 (2004). The SBA.s SBIR policy directive (SBA Policy Directive) is located at www.sba.gov/sbir/SBIR-PolicyDirective.pdf.
4. The SBA announced its intention to amend Section 121.702 in the Federal Register on June 4, 2003, 68 Fed. Reg. 33412. The final rule and accompanying SBA discussion of the public comments on the rule were published in the Federal Register at 69 Fed. Reg. 70180 on December 3, 2004.
5. To be eligible for the SBIR program, an SBC must, in addition to meeting the ownership/control requirement, be for-profit, have 500 employees or fewer, have a place of business in the United States, and operate primarily in the United States or make a significant economic contribution to the U.S. economy. SBA Policy Directive, Sections 3(v), 6(a)(1). There are also further SBIR requirements applicable at the program level.
6. E.g., Size Appeal of CBR Laboratories, Inc., SBA No. SIZ-4423 (Jan. 10, 2001) (the terms .individuals. and .citizens. in Section 121.702(a) means only .natural persons,. and not entities such as corporations).
7. 69 Fed. Reg. at 70181, 70183-84. When the SBA gave notice of the proposed change to Section 121.702(a), it also observed that the prior restrictive policy caused .potential SBIR awards [to] go unawarded. and had resulted in the .anomalous situation. that a parent with a wholly-owned subsidiary was eligible for SBIR funding, but the subsidiary could not compete for SBIR funding in its own name. Notice of Proposed Rule, 68 Fed. Reg. 33412 (June 4, 2003).
8. To accomplish the change, SBA renumbered the existing ownership provision of Section 121.702 as subsection 121.702(a)(1)(i), and added a new subsection 121.702(a)(1)(ii) with the provision permitting subsidiaries:
§ 121.702 What size standards are applicable to the SBIR program?
To be eligible for award of funding agreements in the SBA.s Small Business Innovation Research (SBIR) program, a business concern must meet the requirements of paragraphs (a) and (b) below:
(a) Ownership and control.
(1) An SBIR awardee must (i) be a concern which is at least 51% owned and controlled by one or more individuals who are citizens of the United States, or permanent resident aliens in the United States; or
(ii) Be a concern which is at least 51% owned and controlled by another business concern that is itself at least 51% owned and controlled by individuals who are citizens of, or permanent resident aliens in the United States[.]
9. 69 Fed. Reg. at 71083.
10. 68 Fed. Reg. at 33412-13, 33415-16.
11. Section 121.702(a)(1)(ii) expressly states the subsidiary must be .51% owned and controlled by another business concern. (italics added), and the SBA.s discussion accompanying the final rule reiterates the point that the 51% ownership/control must be held by a single firm, 69 Fed. Reg. at 70183 (.The revised rule now allows businesses owned and controlled by no more than one other for-profit business concern to participate in the SBIR program. (italics added).)
12. The SBA.s rather complex affiliation rules are contained at 13 C.F.R. § 121.103. In general, a VCC affiliate would be any entity owned or controlled by the VCC or its controlling shareholders or management. The issue of VCC.s affiliation under the SBIR program has generated considerable interest, and the SBA published, simultaneous with the December 3rd final rule, an Advance Notice of Proposed Rulemaking that sought, among other issues, public comment as to whether VCCs should be excluded from the affiliation rules for purposes of the SBIR program, 69 Fed. Reg. 70197, 70201-02. The comment period closed February 1, 2005; the SBA has as yet taken no action.
13. 69 Fed. Reg. at 71083 (.The SBA believed that there would be about 50 to 100 concerns that might benefit . . . commenters did not offer estimates, but generally agreed with the SBA.s estimates..)
14. 69 Fed. Reg. at 70182.
15. The .clarification. is discussed at 69 Fed. Reg. at 70182. Whether the new provisions constitute a clarification or new policy is debatable.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.