On December 27, 2012, the U.S. Small Business Administration (“SBA”) released a final rule amending its regulations governing size and eligibility for the Small Business Innovation Research (“SBIR”) and Small Business Technology Transfer (“STTR”) programs. The final rule implements provisions of the National Defense Authorization Act for Fiscal Year 2012 (“Defense Authorization Act”), which extended the SBIR and STTR programs for six years. The final rule became effective on January 28, 2013 and can be viewed here.
Expanded Ownership and Control Requirements
Consistent with the prior rule, the new rule makes eligible SBIR and STTR applicants that are more than 50% owned and controlled by U.S. citizens, permanent resident aliens, or one or more domestic business concerns which are themselves more than 50% owned and controlled by U.S. citizens or resident aliens.
In addition, the new rule now expressly permits participation in the SBIR program – but not the STTR program – by concerns that are majority-owned by multiple domestic venture capital operating companies, private equity firms or hedge funds (collectively “investment firms”), or any combination of investment firms, so long as no single investment firm holds a 50% or greater stake in the company. In order to qualify for this exception, the investment firms must have a place of business located in the United States and be created or organized in the United States, or under any law of the United States or of any State.
When calculating ownership, control and affiliation, the SBA clarified that it will review companies’ equity ownership on a fully diluted basis, meaning that the SBA will consider the total number of shares or equity that would be outstanding if all possible sources of conversion were exercised. The rules specify that this includes, but is not limited to, the following: outstanding common stock or equity, outstanding preferred stock (on a converted to common basis) or equity, outstanding warrants (on an as exercised and converted to common basis), outstanding options and options reserved for future grants, and any other convertible securities on an as converted to common basis.
Revised Size and Affiliation Requirements
Subject to further review by the SBA, the final rule retains the requirement that each SBIR or STTR awardee, together with its affiliates, must not have more than 500 employees.
The final rule provides that an SBIR or STTR applicant will be deemed to be an “affiliate” of an entity that owns or controls more than 50% of the applicant’s voting stock or an entity that owns and controls more than 40% of the applicant’s voting stock if there are other circumstances that demonstrate the minority shareholder has the power to “control” the applicant. Under the rule, it does not matter whether control is exercised, so long as the power to control exists. If no individual or entity is found to control, the SBA will deem the Board of Directors to be in control of the applicant.
Consistent with the old rule, the new rule provides for a variety of circumstances in which applicants can be found to be “affiliated” with individuals and entities, including the terms of certain stock options, convertible securities or agreements to merge, common management, identity of interest, the newly organized concern rule, joint ventures, the ostensible subcontractor rule, license agreements and the totality of the circumstances.
Importantly, the new rule provides that if an investment firm is a minority investor in the awardee, the awardee will not be deemed to be “affiliated” with other portfolio companies of the investment firm unless: (i) the investment firm owns a majority of the portfolio company; or (ii) the investment firm holds a majority of the seats on the board of directors of the portfolio company.
Timing of Size and Eligibility Determination
The size and eligibility status of a concern for the purposes of a funding agreement is determined at the time of the award for both Phase I and Phase II SBIR and STTR awards, or on the date of the request for a size determination, if an award is pending. This was a significant change from the proposed rule, under which size and eligibility would have been determined both at the time of submission of the funding agreement offer and at the time of the award.
Under the final rule, if an awardee grows to an excess of 500 employees during the term of the award, it may continue to perform activities covered by the grant. However, if the awardee merges or is acquired it may only perform the grant for the current funding period and will have to re-certify its size before the agency may exercise an option to extend the grant. Also, for funding agreements with durations of longer than five years, the awardee must re-certify its small business size no more than 120 days prior to the end of the fifth year of the funding agreement
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