SBIR, Private Financing and OTs

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The Small Business Innovation Research (SBIR) program was established in the 1980’s.  Authorizing legislation is 15 U.S.C. 638. The SBIR program taxes Federal agencies with large R&D outlays a small percentage of their extramural R&D budget for funding. The purpose is to promote commercialization of innovative technologies by small businesses. The SBIR statute policy and goals point to small businesses as playing key roles in economic development and job creation. The program aims to enhance small businesses innovation through access to federal R&D funding and other assistance. For some agencies, commercialization is taken literally, aimed at enhancing the national economy and well-being through development of innovative products. Some mission-oriented agencies, like the military departments and defense agencies, use SBIR programs to support commercialization of items that are of potential interest to the agency which will become the primary market for the developed product. The statute recognizes this as a legitimate approach.

In this article we explore two issues related to the SBIR program. First, what award instruments may an agency utilize in the program and specifically, may an “other transaction” (OT) be used. Second, is private investment in SBIR firms or projects permissible and, if so, should the government play a role in connecting SBIR firms with private capital?

In addressing these questions, it is pertinent to review the basic eligibility requirements for a company’s participation. This also addresses in part the second question. A company participating in the SBIR program must be:

  • A small business with 500 or fewer employees
  • Independently owned and operated and organized for profit
  • Must have its principal place of business in the United States
  • At least 51% owned by U.S. citizens or lawfully admitted permanent resident aliens
  • Work must be performed in the United States
  • The Principal Investigator must spend more than one-half of the time employed by the proposing firm
  • A minimum of two-thirds of the research work must be performed by the proposing firm in Phase I and one-half in Phase II.

The SBIR program is divided into three phases. The initial award results from an SBIR competitive call for proposals. Phase I awards are for what might be called concept definition to assess scientific and technical merit and feasibility for commercialization. Phase II awards result from a down-select among companies that executed phase I awards. Scientific and technical merit based on phase I results and feasibility for commercialization are used as the selection criteria. In phase II the concept is further developed and typically takes on demonstrable form as in a prototype. Phase III involves further development leading to full product development. Phase III is to be conducted with commercial funding or non-SBIR government program funding.

Other Transactions as SBIR Award Instruments 

The SBIR statute defines a “funding agreement” as a contract, grant or cooperative agreement. It does not use the term “procurement contract” (the term used in the Federal Grant and Cooperative Agreement Act, FG&CA, 31 U.S.C. 6301-6306) and in least one instance uses the term contract rather than funding agreement. There is no express prohibition or inclusion of OT’s as a funding instrument. DARPA has used OT’s selectively in its SBIR program and may be the only agency to do so. Many agencies, including DOD for example, use procurement contracts. Others such as National Science Foundation use grants. Yet others (National Institutes of Health) use a mix of procurement contracts and grants. I have found no example of a cooperative agreement being used for SBIR although they are used in the related STTR program. Interestingly, the only authorized instrument with the word “agreement” in it apparently is not used as a “funding agreement.”

General reasons indicating that OT’s are authorized are (1) they are generically “contracts” even if not procurement contracts, (2) a prototype OT can be used in circumstances in which a procurement contract could also be used, (3) the SBIR statute does not expressly prohibit their use. Consistent with the FG&CA, the primary purpose for using a procurement contract is to acquire goods and services for the direct benefit and use of the government. That is not the primary purpose of the SBIR program. The SBIR program statute’s second section is titled Assistance to Small-Business Concerns. The program’s purpose is to assist in the commercialization of federally funded R&D. The government may end up benefiting by being able to purchase a successfully commercialized product. That purchase takes place once an SBIR project is successful typically during or after phase III in which there is no SBIR funding.

Note, OTs under 10 U.S.C. 4021 (4022 OTs are carried out under the authority of 4021) are “additional forms of transactions authorized” and may be used “in addition to contracts, grants or cooperative agreements…” Thus, for DOD at least OTs may be used in addition to expressly authorized SBIR “funding agreements” – contracts, grants or cooperative agreements. This point was reinforced in the National Defense Authorization Act of 2018 when Congress amended 10 U.S.C. 4022 to add the proviso “(including small businesses participating in a program described under section 9 of the Small Business Act (15 U.S.C. 638)” in subsection (d)(1)(B).

OT’s are well suited to a program such as the SBIR, especially as implemented by DOD where the program emphasizes commercialization but also desires a potential payoff.  Use of a procurement contract seems inconsistent with the primary purpose definition in FG&CA as well as the characterization of the program as assistance rather than acquisition. DOD might do well to reconsider its use of procurement contracts in the SBIR program.

Private Capital and the SBIR Program

Private investment in SBIR projects or companies is not prohibited but recognized in the statute. However, if private investment results in a small business becoming an affiliate of another business, the other business’ employees are included in the count for purposes of determining small business status. This discourages equity investment by large business or even by another small business depending on total number of employees. Foreign ownership could also affect eligibility for SBIR participation. Revenue return investments through royalties on product sales or other non-equity investments would not affect small business status.

Phase II selection criteria includes the following which suggests attraction of private capital is a definite positive factor:

(i) the small business concern’s record of successfully commercializing SBIR or other research;

(ii) the existence of second phase funding commitments from private sector or non-SBIR funding sources;

(iii) the existence of third phase, follow-on commitments for the subject of the research; and

(iv) the presence of other indicators of the commercial potential of the idea;

(emphasis supplied)

Venture capital, hedge fund and equity investments in SBIR companies are mentioned in several sections of the SBIR statute, generally with respect to reporting requirements. If such investments were not authorized, they would hardly need to be reported. Revenue return investments through royalties on product sales or other non-equity investments are not required to be reported.

The statute places a limit on the number of SBIR awards that can be made to companies with majority ownership by multiple venture capital operating companies, hedge funds or private equity firms. For DOD organizations the limit is 15% of awards. This limitation appears to have discouraged some agencies. A few agencies do not permit small business with majority ownership by financial institutions to participate in their SBIR programs. Only the National Institutes of Health (NIH) has made multiple awards to such firms. By clear rules of statutory construction, however, the express limit on majority ownership means there is no limit on companies whose ownership includes such investments constituting less than majority ownership. Moreover, there are no limits relating to bank loans or other forms of private financing of companies or projects.

Each of the military services has recognized the potential importance of private capital in government R&D programs by various initiatives exploring working with private finance. Congress recognized the importance of private sources of capital in the 2018 National Defense Authorization Act by amending 10 U.S.C. 4022 (d)(1)(C) to read “funds provided by sources other than the Federal Government.” Earlier Congress authorized the creation of an Army non-profit venture capital corporation engaged via a section 4021 OT, indicating Congress clearly saw a roll for government in connecting venture capital with firms capable of providing technology or products to support the national security mission.

The benefits to the government of private investment in companies performing R&D for the government are many. The government benefits by being able to leverage the private funding. Financial risk is reduced for both funding sources compared to single source. Private funding can flow to the performing company even if the government’s budget process delays government funding. Government sponsored research can potentially be accelerated by the addition of non-government resources. The SBIR program provides a potential testing ground for government personnel to interact with the financial community to the mutual advantage of government funder, R&D performer, and financing organization. OTs can provide the flexibility to structure innovative business arrangements including seamless transition from research and prototyping to production.


The use of OTs as award instruments for SBIR companies is legally permissible and allows for the kind of flexibility the SBIR statute calls for. The infusion of private capital to support small businesses participating in the SBIR program is in the interest not only of SBIR companies but also the government. It would be smart for government agencies engaging in the SBIR program to establish policies and techniques that facilitate SBIR firms access to private capital. The SBIR program can provide experience for government agencies to engage the financial community more broadly in support of government funded R&D.  There are existing alternative pathways, approaches and tools for those who can see outside of the bubble and desire improved outcomes, speed and affordability for fielding new capabilities to the force and fleet.

written by Richard L. Dunn

2 Responses

  1. Timothy Stecker

    In Mr. Dunn’s article in Vol. 32 of the Nash & Cibinic report, he states “[i]n the litany of terms
    contract, grant, or cooperative agreement appearing together, contract almost always means procurement contract.” Yet in this article, it seems as though those words together do not mean procurement contract. Can you clarify? Trying to evaluate whether the SBIR statute applies to OT’s using the framework of the ABA and the Nash & Cibinic report.

    • admin

      Arguing that OTs are generically “contracts” tends to undercut the stronger arguments for their use as SBIR award instruments. Sorry for any confusion. OTs may used in the SBIR program because of 10 U.S.C. 2358(b)(5) and the language in 10 U.S.C. 2371 that DOD OT authority is “in addition to the authority provided in section 2358 of this title to use contracts, cooperative agreements and grants…” Note that prototype OT per 2371b are executed under the authority of section 2371 and thus the “in addition” language also applies to them.