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SBA Rules: Investment Funds Can Now Be Majority Owners of SBIR Companies

Joel N. Ephross and G. Matthew Barnard of Duane Morris LLP



The Small Business Administration (SBA) has 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.

Background

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.


[1] See 77 Fed. Reg. 76215.

[2] See National Defense Authorization Act for Fiscal Year 2012, Public Law 112–81.

[3] The determination of ownership is calculated on a fully diluted basis.

[4] 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.

[5] 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.

Joel N. Ephross, Partner, JNEphross@duanemorris.com

Joel N. Ephross practices in the area of corporate law with an emphasis on corporate finance, mergers and acquisitions, real estate, and physical and financial trading. He has structured debt transactions, including project finance; real estate lending; leveraged and non-leveraged lease financings; structured finance; asset securitization; bankruptcies and reorganizations; letters of credit; and credit enhanced transactions. He has worked in all aspects of commercial real estate, including leases, acquisitions and divestitures, mortgages and easements. Mr. Ephross has substantial experience in all aspects of energy and natural resources, including mining, oil and gas leases, oil field services, midstream and power generation. He has experience in connection with domestic and cross-border transactions. Mr. Ephross' practice includes corporate governance matters, including advising on issues of fiduciary responsibilities and Sarbanes-Oxley matters, and he has represented special committees conducting investigations and advising on strategic alternatives.

Full Bio (http://www.duanemorris.com/attorneys/joelnephross.html)


G. Matthew Barnard, Associate, GMBarnard@duanemorris.com

G. Matthew Barnard practices in the area of corporate law. Mr. Barnard has experience with mergers and acquisitions, private equity financings and fund offerings, as well as general corporate law.

Mr. Barnard is a 2006 graduate of Temple University Beasley School of Law. He also received an M.B.A. from Temple University, Fox School of Business and Management, and a B.S. in Finance from Pennsylvania State University.

Full Bio (http://www.duanemorris.com/attorneys/gmatthewbarnard.html)



Duane Morris LLP

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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Duane Morris LLP. This work reflects the law at the time of writing.