Washington Editor

The biotechnology industry is hoping a bill passed last week by the House will lead to the restoration of the original eligibility requirements for Small Business Innovation Research (SBIR) grants.

The Small Business Administration (SBA), which oversees the SBIR program, has declared in recent years that firms that had venture capital investment in excess of 50 percent no longer met the criteria for the grants.

If enacted, the Small Business Investment Expansion Act, H.R. 3567, would again permit small firms that are majority backed by venture capital companies to qualify for the SBIR grants.

A companion bill has yet to be introduced in the Senate.

The SBIR program was created in 1982 under the Small Business Innovation Development Act to provide competitive grants to small businesses in the U.S. to encourage exploration of new technologies.

The program requires the 11 participating government agencies, including the National Institutes of Health (NIH), to set aside a portion of their research and development funds for awards to small businesses.

Awards for Phase I projects can be as high as $100,000. Phase II project awards are generally as high as $750,000 per year for up to two years. However, the program gives agencies the flexibility to award higher amounts.

The median award size of SBIR grants from NIH in fiscal year 2006 was $143,725 for Phase I projects and $415,952 per year for Phase II projects.

Agencies make SBIR awards based on certain qualifications, degree of innovation, technical merit and future market potential.

To be eligible for the grants, the SBA requires firms to be at least 51 percent owned by one or more individuals who are U.S. citizens or permanent resident aliens. A firm, together with its affiliates, can have no more than 500 employees.

When determining the size of a business, the SBA considers the number of direct employees at the company and any affiliated firms' employees. Companies are affiliates of each other if the SBA determines that another business has either affirmative or negative control.

Under current rules, a venture capital company that holds a minority share in another business can be considered an affiliate of that business. If the SBA determines that a venture capital company is affiliated with the firm, not only are the employees of the venture capital company included in the size determination, but so are the employees of all other firms that the venture capital company is invested in.

If a majority of a firm's equity is held by multiple venture capital operating companies, regardless of the size of any single company's share, it is not independently owned and operated and therefore precluded from being considered a small business by the federal government.

But the Biotechnology Industry Organization (BIO) has argued that SBA's interpretation in the past few years of the SBIR eligibility requirements is not what lawmakers intended in 1982. "Congress never intended to make a distinction about venture capital backing" when it used the term "individuals," said BIO CEO Jim Greenwood.

Rather, he said, lawmakers intended to ensure that the grants went to firms that were owned by American citizens.

Small biotechnology firms that otherwise are eligible for the SBIR grants, Greenwood said, are caught in a semantic argument about the 1982 legislation's meaning of an "individual."

The bill that passed by the House last week, he said, will correct that problem by allowing small firms to access SBA programs while also receiving necessary research and development investments from eligible venture capital companies. BIO, he said, is working with members of the Senate to draft a companion bill.

NIH Director Elias A. Zerhouni has argued that the SBA's limits on SBIR grants "unduly restrict" the ability of NIH to fund high-quality, small companies that receive venture capital investment. "As a result, NIH must turn away many deserving applicants, and the goals of the SBIR program are being undermined," he told SBA in a June 2005 letter.

SBA's recent restrictions on SBIR grants "dries up" federal funding for early stage ideas that "show strong signs of likely success," Zerhouni asserted.

SBIR grants, said Steven J. Mento, CEO of San Diego-based Conatus Pharmaceuticals Inc., help firms progress scientific concepts that venture capital companies or foundations are often reluctant to fund until the idea shows promise.

The grants, he added, are needed at the "sweet spot" of development that sits between an academic exercise and a compound's advancement to the clinical stage.

Mento, whose company has nine employees, said the grants have been "taken off the table" for Conatus because its four venture capital investors - Aberdare Ventures, Advent Venture Partners, Bay City Capital and Gilde Healthcare Ventures - own more than 50 percent of the firm.

The grant restrictions imposed by the SBA in recent years, he said, have been a detriment to small biotechnology firms' ability to move forward on experimental technologies.

Gerard J. McGarrity, executive vice president of scientific and clinical affairs of Gaithersburg, Md.-based Virxsys Corp., said that while his current company has not yet been affected by SBA's recent determination about eligibility, his previous firm was harmed by the decision.

Rockville, Md.-based Intronn Inc., where McGarrity formerly served as CEO, had to shut down a cystic fibrosis research project and lay off several employees after an NIH SBIR Phase II grant was rescinded due to the SBA's reinterpretation about the eligibility requirements, he said.

NIH, McGarrity said, had called the cystic fibrosis project "one of the most innovative, thoughtful and exciting" for which the agency had received an SBIR grant application.

Ironically, he said, it was an earlier SBIR grant award that attracted venture capital investment to Intronn.

"The SBIR grant was the seal of approval that gave the project the credibility" the venture capital firms were seeking, McGarrity said. "But because of our victory," he added, "we were punished."

McGarrity noted that Virxsys recently acquired Intronn and may pursue the cystic fibrosis project.

However, he said, the project has been delayed by at least four years by the loss of the SBIR grant, and the scientists that developed the original cystic fibrosis project at Intronn have gone on to work for other firms.

A recent BIO survey found that 50 percent of small biotech firms are ineligible for SBIR grants because of their capital structure.

"Just because a company has succeeded in having venture capital for one of its projects should not disqualify it from gaining government grants that are very valuable to the project," Greenwood argued.

Because SBA has "misinterpreted" the SBIR eligibility requirements in recent years, projects have been "stymied" and "left sitting in the laboratories," Greenwood charged, which, he maintained, "is not good for advancing health care."