The Small Business Administration (SBA) recently amended the rules relating to its Small Business Innovation Research (SBIR) program and Small Business Technology Transfer (STTR) program.1 The new SBA rules implement the provisions of the National Defense Authorization Act for Fiscal Year 2012,2 which included changes to the SBIR and STTR programs. These rule changes increase the opportunity for private equity and venture capital investment in SBIR program participants and may preview future revisions to the SBA's general affiliation rules.
Prior to the new SBA rules, businesses could not participate in the SBIR program unless they were majority owned and controlled by U.S. citizens or permanent resident aliens or by a single business that was majority owned and controlled by U.S. citizens or permanent resident aliens. In addition, such participating businesses could have no more than 500 employees, including the employees of their affiliates.
Permitted Ownership by Venture Capital Operating Companies, Hedge Funds and Private Equity Firms
Under the new SBA rules, a business participating in the SBIR program is no longer required to be majority owned and controlled by U.S. citizens or permanent resident aliens or by a single business that is majority owned and controlled by U.S. citizens or permanent resident aliens.3
A participating business may now be majority owned by multiple domestic venture capital operating companies, hedge funds or private equity firms, provided that: (i) no single domestic venture capital operating company, hedge fund or private equity firm owns more than 50 percent of the business; and (ii) each such venture capital operating company, hedge fund or private equity firm must have a place of business located in the United States and be created or organized in the United States or under the law of the United States or of any state. By way of two examples, a business owned by two venture capital operating companies, each owning 49 percent of the business, or a business owned by four venture capital operating companies, each owning 25 percent of the business, would not be prohibited from participating in the SBIR program due to such ownership structures.
Changes to Affiliation Rules
The SBA's affiliation rules provide that two businesses are deemed to be affiliated if one business controls or has the power to control another business or when a third party controls or has the power to control both businesses. Depending on the holdings of any one investor in a business relative to the holdings of the other investors in the business, the application of such affiliation rules may result in a finding of affiliation even if the initial investor owns less than 50 percent of the business. Such a finding could result in the employees of the business being combined with the employees of the portfolio companies of the investor, making such business ineligible for the SBIR program. To mitigate this issue, the new SBA rules include changes to the foregoing affiliation rules, which include new limitations on when the portfolio companies of an investor will be deemed to be affiliates of the business. While a determination of affiliation under the new SBA rules remains a fact-dependent analysis and will need to be reviewed on a case-by-case basis, with respect to portfolio companies, the new SBA rules provide that if an investor is a minority investor in the business, the business will not be deemed to be affiliated with a portfolio company of the investor unless the investor owns a majority of the portfolio company or the investor holds a majority of the seats on the board of directors of the portfolio company.4
For affiliation purposes, the SBA also takes into account whether a new business is an affiliated entity of an existing business. To add clarification to this aspect of the affiliation rules, the new SBA rules provide that a business that has been actively operating continuously for more than one year will no longer be considered "new" for purposes of this affiliation rule.5 For affiliation purposes, the SBA may also find that affiliation exists if two or more persons are economically dependent through contractual or other relationships. The new SBA rules provide a clear rule that affiliation may be found based upon economic dependence if the business receiving an SBIR/STTR award relies upon another entity for 70 percent or more of its receipts.
Timing of Size and Eligibility Determination
Determination of a business' size and eligibility is made at the time of the award. If a business' size and eligibility status changes during the term of the award, the business may continue to perform the activities for which the award was provided and will not need to re-certify its size and eligibility status. However, a business must re-certify its status if the business merges or if it is acquired by another entity. A business also has to re-certify its status if the award agreement is for a period of longer than five years.
For Further Information
If you have any questions about this Alert, please contact Joel N. Ephross, G. Matthew Barnard, any member of the Corporate Practice Group or the attorney in the firm with whom you are regularly in contact.
See 77 Fed. Reg. 76215.
See National Defense Authorization Act for Fiscal Year 2012, Public Law 112–81.
The determination of ownership is calculated on a fully diluted basis.
It is worth noting that a scenario now exists under the SBA rules where a business may be small for SBIR purposes and large for all other SBA purposes.
If a business is "new," other factors will continue to influence the finding of affiliation, including whether the former or current officers, directors, principal stockholders, managing members, general partners or key employees of one concern serve as the new concern’s officers, directors, principal stockholders, managing members, general partners or key employees, and the one concern is furnishing or will furnish the new concern with contracts, financial or technical assistance, indemnification on bonds and/or other facilities, whether for a fee or otherwise.