Often in the late stage of deals, misrepresentations in small business status may be uncovered and revenue expectations dependent on government funding may have to be reduced. When acquiring a small business involved in federally funded research and development activities, before progressing to this stage of the deal, it is advisable for the parties to diligently investigate the potential for loss of eligibility and cessation of Small Business Innovation Research (SBIR) funding.
Multiple categories of government procurements, including those for research and development activities, depend on socio-economic status, and these procurements permit expenditure of federal funds only on work performed by eligible entities, all with different eligibility requirements. These include, among others, procurements restricted to 8(a)-certified entities, self-certified small business entities, and veteran-owned and service-disabled veteran-owned small businesses under both Small Business Administration (SBA) regulations and a separate statutory authority, which applies different standards only to purchases by the VA. However, the eligibility that is perhaps of greatest importance to many startups or other potentially small businesses with promising early-stage drugs, biologics, devices, countermeasures, and diagnostics is eligibility under the federal SBIR/Small Business Technology Transfer (STTR) programs. The SBIR program is intended to encourage domestic small businesses to engage in federal R&D with the potential for commercialization. The STTR program also funds R&D but through a structure that requires collaboration between the small business and a research institution with intent to bridge the gap between performance of basic science and the commercialization of resulting innovations. DOD and NIH SBIR/STTR funding together is over $1.5 billion per year.
To be eligible for this funding,
Note that SBA SBIR guidance appears to prohibit the 50% ownership and control test from being satisfied, for example, by a combination of venture capital and individual ownership interests. For purposes of determining ownership and control, SBA will consider equity ownership on a fully-diluted basis.
Proposed transactions typically run into problems regarding existing or continued eligibility to receive SBIR awards or continued funding when, under certain circumstances, the number of employees both at existing or proposed investors and at all other companies controlled by these investors are not taken into account when calculating the size of the firm to be acquired (affiliation), when the right type of individual or corporate entities do not own and control the firm to be acquired, when the ownership requirement is met but controls are implemented by non-qualifying owners to prevent the qualifying ownership from fully controlling management and day-to-day operation of the company, and when required notices are not given to the government upon a change in eligibility.
Accordingly, investors must carefully consider the arcane and complex SBA affiliation rules that potentially would require consideration of numbers of employees at direct and indirect parents, subsidiaries, and other affiliates of the target company as well as employees of both the controlling owners and other companies controlled by these owners (even if only portfolio companies of an investor operating in unrelated industries) in determining whether the 500-employees SBIR size standard is met. Companies can be affiliated if one has the power to control more than 50% of the other's voting equity, through common management or board control, through identity of interest either between businesses controlled by family members or when one company is overly dependent on the other, if one is a newly organized firm arising from and closely associated with the other firm, if the companies are joint venturers, or if a subcontractor of the potentially SBIR-eligible entity performs primary and vital requirements of the funding agreement or is heavily relied upon by the potentially eligible entity. Affiliation may be found on a totality of the circumstances, even though no single factor is sufficient to constitute affiliation.
Because an investor may control both the target and other entities in related or unrelated industries, often it is not the number of employees at the investor that pushes the aggregated total number of employees over the 500-employee SBIR size standard but the employees from the other entities controlled by the investor, including portfolio companies. The one exception to this is that portfolio companies of an investor affiliate that is a venture capital operating company, a hedge fund, or a private equity firm will not be deemed affiliates of the SBIR candidate firm if the investor affiliate has only a minority interest in the SBIR candidate firm and has only a minority ownership interest in the portfolio company.
Investors also must carefully evaluate whether the composition of the proposed ownership meets SBIR requirements and whether, even if it does, proposed control structures would provide non-qualifying owners with control over aspects of management or the day-to-day operations of the target company, even though such control might, outside of the SBIR context, be considered a normal and expected condition of investment in a small business.
If you have any questions or would like more information on the issues discussed in this Insight, please contact the following Morgan Lewis lawyer:
 A firm also is eligible if owned and controlled by a joint venture when each of the entities participating in the joint venture itself would be eligible.