New SBIR Rule Opens Door for Private Equity Investment and Contains Significant Affiliation Revisions

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1 Litigation Department Government Contracts Client Alert January 15, 2013 New SBIR Rule Opens Door for Private Equity Investment and Contains Significant Affiliation Revisions by Les Lepow and Damien Specht A year ago, the Fiscal Year 2012 National Defense Authorization Act, passed on December 31, 2011, included significant revisions to the Small Business Innovation and Research ( SBIR ) program. These new provisions opened the door for increased venture capital investment in the cutting edge small businesses that participate in the program. [1] Recently, the Small Business Administration ( SBA ) issued its final regulations for implementing these changes. [2] The new regulations and SBIR affiliation revisions increase the opportunity for venture capital investment in small business SBIR participants and may set the stage for future revision of affiliation rules generally. If these regulatory changes are expanded beyond SBIR to small business procurement matters, they will likely have a material impact on small business set aside strategies. Majority Ownership of SBIR Firms by Venture Capital Operating Companies, Hedge Funds and Private Equity Firms Until recently, participation in the SBIR program was limited to firms that were majority owned by individuals who were U.S. citizens or permanent resident aliens (or by another business that is itself majority owned and controlled by individuals who are U.S. citizens or permanent resident aliens) and had 500 or fewer employees (including the employees of its affiliates). [3] These rules made it difficult for many private equity firms, which can have dozens of affiliates with thousands of employees, to take a large equity position in SBIR firms. As a result, some SBIR firms reported difficulty raising the required funds to grow their businesses. SBA s new regulations include significant revisions to these requirements. [4] No longer must an individual own a majority of an SBIR firm. Instead, an SBIR firm can now be owned in majority part by multiple venture capital operating companies, hedge funds, or private equity firms. Potential investors should be aware that ownership must be by multiple venture capital firms, and sole ownership of more than 50% by an equity firm or similar entity will not qualify a business for this program. In addition, although SBIR funds generally continue to be unavailable to companies majority-owned or controlled by a large business or foreign entity, the rules are slightly different for venture capital companies, hedge funds, and private equity firms. Instead of analyzing the foreign ownership of these firms, equity firms, hedge funds, and venture capital companies must only 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 to own large minority interests in an SBIR firm. This change will not, of course, eliminate any security issues related to foreign ownership and control Jenner & Block LLP. 353 N. Clark St. Chicago, IL Jenner & Block is an Illinois Limited Liability Partnership including professional corporations. This publication is not intended to provide legal advice but to provide information on legal matters. Transmission is not intended to create and receipt does not establish an attorney-client relationship. Readers should seek specific legal advice before taking any action with respect to matters mentioned in this publication. Attorney Advertising. Prior results do not guarantee a similar outcome.

2 This new opportunity does not come without a cost as every SBIR awardee must state whether it has received any venture capital, hedge fund, or private equity firm investment or is majority-owned by such entities. If so, it must disclose the amount of such investment received in the public database of SBIR fund recipients. Additionally, each awardee must disclose (among other matters) the percentage of ownership of the awardee held by a venture equity firm. This information will appear only in the already-existing, non-public government database of SBIR fund recipients. One of the most interesting aspects of this rule is that it does not include an analysis of the ownership or control of the private equity firms that together may own up to 98% of an SBIR firm (up to 49% interest each) or even 100% split between three firms. As a result, if there are no other indicia of affiliation as discussed below, a large business could now own or control a private equity firm that, in turn, controls the largest block of stock in an SBIR firm. Moreover, the same investors could own several private equity firms that, in turn, control the overwhelming majority of an SBIR awardee. Although SBA considered exactly this possibility, it decided to leave this latter scenario open because [w]e do not believe that investors will set up several VCOCs and have those VCOCs invest in an SBIR awardee simply to skirt the limitations on the awards to small businesses that are majority-owned by VCOCs. [5] This rule may be for the best, as any effort to determine the overlapping ownership structure of equity firms could make such a rule nearly impossible to enforce. Ownership percentages will be calculated on a fully diluted basis. SBA s commentary explains that all of the following would be considered in making a determination of ownership: Outstanding common stock, all outstanding preferred stock (on a converted to common basis), all outstanding warrants (on an as exercised and converted to common basis), all outstanding options and options reserved for future grants, and any other convertible securities on an as converted to common basis. This is a change from the proposed rule but is not inconsistent with the manner in which SBA performs ownership determinations for size purposes. Affiliation Changes In its Final Rule, SBA recognized that granting permission to private equity firms to own large minority blocks of SBIR firms would not be effective without revisions to the applicable affiliation rules. Although the current changes are limited to the SBIR program, they may set the stage for future revisions to small business affiliation generally. Affiliation exists when one business controls or has the power to control another or when a third party (or parties) controls or has the power to control both businesses. Control may arise through ownership, management, or other relationships or interactions between the parties. [6] When two or more firms are affiliated, SBA combines the receipts, employees, or other measure of the business, including all domestic and foreign affiliates. [7] Without changes to SBA s affiliation analysis, small businesses that have significant venture capital investment may find themselves ineligible for small business contracts because their employees and revenue are combined with other portfolio companies of the investor. The Final Rule includes changes designed to mitigate that issue. Minority Shareholder Rule SBA s most significant affiliation revision may be to the minority ownership rule. Outside the context of the SBIR program, the SBA will find an entity that owns 50% or more of a small business to control that business. [8] However, SBA will also find that owners of as little as 24% of a small business control that business if (1) the stock is widely held and (2) that block of stock is large as compared to other blocks. In addition, if two blocks of stock are equal or approximately equal in size and the aggregate of the holdings is large as compared with other stock holdings, then SBA presumes each person to control the business concern. Under this rule, two private equity firms that each own relatively large blocks of stock of a small business firm would be deemed to be affiliated with that firm, and that firm would almost certainly be considered to be large. 2

3 To avoid this result and to provide a black letter rule, SBA s Final Rule limits the application of the minority shareholder rule to holders of at least 40% of an SBIR firm. Ownership of less than 40%, even if that block is large as compared to other holders, will not, in and of itself, result in an affiliation finding. In fact, even ownership of 40% will not result in an affiliation finding unless that finding is supported by the totality of the circumstances, a broad test that considers all possible factors of affiliation. This change should provide equity investors with increased certainty that less than a 40% investment is less likely to result in an affiliation finding than in the past. Exception for Portfolio Companies If, despite the new relaxed minority shareholder rule, an equity firm is found to be affiliated with an SBIR company, that does not end the small business analysis. As discussed above, private equity firms do not generally, in and of themselves, have more than the 500 employees required to qualify as a large business under the SBIR program. However, if one includes a private equity firm s portfolio companies, its employee count can expand into the thousands. If that firm is then found to be affiliated with a small business, the small business would be large for SBIR purposes. [9] SBA s Final Rule attempts to resolve this issue by limiting affiliation between portfolio companies and SBIR firms. Specifically, if a venture equity firm that is determined to be affiliated with an SBIR awardee is a minority investor in the awardee, the awardee is not affiliated with a portfolio company of the venture capital operating company, hedge fund, or private equity firm, unless (i) the venture equity firm owns a majority of the portfolio company; or (ii) the venture capital operating company, hedge fund, or private equity firms holds a majority of the seats of the board of directors of the portfolio company. In addition, the rule explains that an SBIR awardee is not affiliated with a portfolio company solely on the basis of one or more shared investors, though affiliation may be found for other reasons. These changes allows equity firms to make multiple minority investments in portfolio companies without exponentially increasing the risk of affiliation. However to take advantage of this portfolio exception, equity firms must be willing to give up majority ownership and board control of their portfolio companies. This may be an unlikely proposition. Affiliation Changes For New Concerns The SBIR program is designed to help small firms with early stage research and development projects. Unfortunately, the program s goals can be frustrated by the fact that these new businesses can be found to be affiliated with other businesses based on the newly organized concern rule and economic dependence. SBA s Final Rule attempts to create affiliation rules for SBIR firms that resolve these concerns. Affiliation may arise under the newly organized concern rule where former or current officers, directors, principal stockholders, managing members, general partners, or key employees of one concern organize a new concern in the same or related industry or field of operation. Factors that may increase the chance of affiliation based on this rule include whether the former employees serve as the new concern s officers, directors, principal stockholders, managing members, general partners, or key employees or if the longstanding concern is furnishing or will furnish the new concern with contracts, financial or technical assistance, indemnification on bid or performance bonds, and/ or other facilities to the new one. [10] It has not been clear, however, when a new concern simply becomes a going concern, independent of its previous affiliation. The Final Rule sets out a clear rule that a concern will be considered new for the purpose of this rule if it has been actively operating continuously for less than one year. This will reduce uncertainty for small business spin-offs that have existed for more than one year. SBA may also find affiliation if two or more persons have an identity of interest, which includes family members with identical or substantially identical business or economic interests or firms that are economically dependent through contractual or other relationships. [11] In the early stages of a business, this test may cause a finding that a business is other 3

4 than small because it receives a large amount of its revenue from a single firm. [12] It is often difficult to determine what constitutes a large amount of revenue, and, as early stage SBIR firms may have few customers, this rule was a significant concern. SBA s Final Rule establishes a black letter rule that affiliation may be found based upon economic dependence if the SBIR/STTR awardee relies upon another entity for 70% or more of its receipts. This is consistent with some [13], but not all, prior precendent. [14] Timing of Size Determination For procurement contracts, the size of a business is measured at the time that firm submits a bid, including price, for a contract. [15] For SBIR awards, however, size is measured at the time of award. In its Final Rule, SBA also addressed how to treat an SBIR business that becomes other than small or is acquired by or otherwise merged with another entity during contract performance. The Final Rule explains that the rule for these circumstances will be the same as it is for procurement contracts. Specifically, an SBIR awardee is permitted to grow to be other than small during the life of the contract, and there is no need for it to re-represent its status on a particular contract or for the government to terminate the contract. However, a small business must recertify its status if it has been acquired by or merged with another business concern or if the contract length is greater than five years, a rarity in SBIR awards. If an SBIR awardee is no longer small at that point, the Government cannot count any options exercised or orders issued against the award as being to a small business. If an SBIR or STTR awardee is acquired during performance of an SBIR or STTR funding agreement; it is permitted to continue working on the funding agreement however, the agency cannot use SBIR funds for the next option on a funding agreement that is a contract or grant or for continuation of a grant. Outstanding Questions In creating new affiliation rules for the SBIR program that are different from the rules for general small business, SBA has created a scenario where a business may be small for SBIR purposes and large for all other purposes. For example, a business that is 30% owned by a large firm where no other party owns more than 1% will likely be found to be affiliated and hence a large business under SBA s standard affiliation rules. However, under SBA s SBIR Final Rule, that business is below the 40% standard for evaluation under the minority shareholder rule, and may be a small business for SBIR purposes. It is not clear how SBA will handle these differences or how firms that are large in one instance and small in another can properly certify their status for SBIR awards. The immediate question that this situation raises is whether the new SBIR affiliation rules are an indication that a more serious revision of broader small business affiliation rules is coming or if these changes are limited to efforts to encourage private equity support for the relatively small pool of SBIR firms. 4

5 [1] National Defense Authorization Act for Fiscal Year 2012 ( Defense Authorization Act ), Pub. L. No , 125 Stat, [2] Small Business Size Regulation, Small Business Innovation Research (SBIR) Program and Small Business Technology Transfer (STTR) Program, 77 Fed. Reg (May 15, 2012) (proposed rule); 77 Fed. Reg (Dec. 27, 2012) (to be codified at 13 C.F.R. pt. 121). [3] 13 C.F.R [4] SBIR and STTR size and affiliation rules will be found at 13 C.F.R , separate from the SBA s general size and affiliation rules found at 13 C.F.R [5] Although the SBA s statement addresses only Venture Capital Operating Companies (VCOCs) and not hedge funds and private equity firms, the context of the preamble makes clear that the same rule applies to all these entities. [6] 13 C.F.R (a)(1). [7] 13 C.F.R (a)(6). [8] 13 C.F.R (c). [9] See Size Appeal of Novalar Pharmaceuticals, Inc., SBA No. SIZ-4977 (2008): finding a business exceeded a 500-employee size standard because it was affiliated with dozens of its venture capital investor s portfolio companies. [10] 13 C.F.R (g). [11] 13 C.F.R (f). [12] But see Size Appeal of Argus and Black, Inc., SBA No. SIZ-5204 (2011): holding that where a concern has only recently begun operations either initially or after a period of dormancy, and is dependent upon its alleged affiliate for only one small contract of short duration, which by itself could not sustain a business, that a finding of economic dependence is not warranted.. [13] Size Appeal of Faison Office Prods., LLC, SBA No. SIZ-4834, at 10 (2007). [14] Avasar Corp., SBA No. BDP-209 (2004): citing Cal Art Landscape, SBA No. MSB-437 (1993), finding that a concern s dependence on another firm for 60% of its revenue may constitute financial and contractual dependence). [15] 13 C.F.R (a). For further information, please contact: Leslie H. Lepow Partner Tel: llepow@jenner.com Damien C. Specht Associate Tel: dspecht@jenner.com 5