Thursday, Sept. 3, 2009 | Call it the battle of the little guy vs. the littler guy.

On one side sit small technology companies that are years, or even decades, away from being able to go public or be acquired, but have had the good fortune of securing venture capital funding. On the other: Even smaller companies that have had to make a go of it with little or no help from venture capitalists because of their size.

At stake is $2 billion-plus in Small Business Innovation Research program money for companies and institutions that are engaged in early stage research.

Venture-backed firms have been excluded from receiving the federal small-business loans for six years because they aren’t considered to be owned by individuals. But these companies and their backers are now fighting that restriction as they scrap like never before for working capital in the face of a barren funding landscape.

Congress is considering legislation that would allow companies funded mostly by venture capital firms a shot at the federal dollars. As things stand now, a company more than 50 percent funded by venture capital is out of the money. A House bill would give venture-backed firms a shot at the entire pot. A Senate version would limit it to a portion — from 8 to 18 percent — of the money.

And beyond the question regarding venture-backed companies, there remains a general sense in the tech community that the U.S. Small Business Administration isn’t changing with the times at a quick enough pace to actually help small companies survive in the current environment.

For example, virtual companies, or companies that outsource their research, are becoming more prevalent in biotech. But they don’t meet the eligibility requirements for SBIR grants.

The issues are hugely important to San Diego, where, save for a few big names like Qualcomm and SAIC, the innovation economy is made up of small companies. The biotech industry alone employs more than 40,000 people, the vast majority working for companies with less than 500 employees, which is the SBA’s threshold for being classified as a small company.

Why It’s Happening Now

Venture capital has long been the lifeblood of small companies in the innovation economy. And ever since the stock market crash, investors have been steadily pulling their money out of venture capital funds and the firms have been more risk-adverse.

As a result, these companies are looking where everyone else is looking for money nowadays: Washington D.C.

Even when times were flush, the smallest companies — those with only a founder and a handful of dedicated employees — didn’t attract venture capital. They rely on SBIR grants, and funds from family members and credit cards, to back their companies.

And, they say, having to compete with venture-backed companies for this money is unfair.

Scott Thacher is in this group. The founder and CEO of Orphagen Pharmaceuticals, a company that is developing therapies for autoimmune diseases like rheumatoid arthritis, says he couldn’t have gotten his company off the ground without SBIR money.

“I worry that if I had gone against companies with more momentum and VC backing, whether I would have gotten my first grant,” Thacher said.

Local tech and biotech industry organizations Connect and Biocom favor the rule change, which would undo a 2003 judge’s ruling against venture firms that they say is based on a technicality. The primary argument of the industry organizations is that just because a company is venture-backed doesn’t mean it isn’t struggling. And an SBIR grant may be a deciding factor of whether a company can get subsequent rounds of venture funding.

“The impression that a venture-backed company is a large corporation that can out-maneuver a small company, is inaccurate,” said Joe Panetta, Biocom’s CEO. “A venture-backed company is a small company.”

Duane Roth, CEO of Connect, said the funding situation has become so dire that some venture-backed companies “might not be able to survive without SBIR money at this point.”

Congress established the SBIR program in 1982 after years of complaining from the technology industry that companies heavily involved in research and development were at a disadvantage for SBA money because they lacked consistent revenue streams. A tech start-up can lose money for years and have to survive year-to-year on foundation grants.

“They like to give money to laundromats, not biotechs,” said Vicki Nienaber, the founder and president of San Diego-based Zenobia Therapeutics.

After the SBIR program was established, biotechs and other research-centric small companies began getting grants administered through federal agencies — such as the National Institutes of Health and the Defense Department — that met a certain threshold for research spending. The grants are administered in two phases. The average amount of a phase one grant is around $150,000. The average phase two grant runs to about $1.5 million.

In 2003, an administrative law judge directed the SBA to exclude majority venture-backed companies from the program because venture capital firms were not individuals, and therefore VC-controlled companies did not meet the SBA’s definition of a small business. The decision made some waves in the research community, but did not become a huge issue because at the time the great credit bubble was still expanding and investors were still flush.

That era is a distant memory now. Michael Weingarten, director of the National Cancer Institute’s SBIR Development Center, said his agency has seen a big jump in applications this year. “The reason is that SBIRs are the only game in town for some of these companies.”

Which is why, say Thacher and others, the most vulnerable need to be protected. The grants are administered through a peer-review system, which gives companies with the money to make impressive presentations a big edge.

“If we are going to go for an SBIR we would have to compete with these specialized teams,” said Michael Wu, founder of locally based NeuroDigiTech, a contract research organization that also makes staining kits for brain tissue research.

“We don’t have an executive team with track record like a venture capital firm.”

But having that track record is important. While the government agencies that administer the grants are going to great lengths to stay impartial on the issue, officials do acknowledge that they want the companies to have a strong business plan.

“There is a major emphasis on a company’s commercialization plan,” Weingarten said. “It is critical that the small businesses we fund be able to raise funding from investors, big pharma and the biotech industry as they are transitioning out of the program.”

And separate from the battle over venture-backed firms, is the emerging question of whether virtual companies should be eligible for the grants. The virtual model, in which a company employs a few executives who oversee the outsourcing of the research and development of a drug or medical device, has become a big deal in biotech.

Such companies aren’t prohibited from applying for SBIR grants, but the eligibility requirements make it almost impossible for virtual companies to qualify. The biggest roadblock for these companies is the requirement that recipients spend less than 40 percent on outsourcing costs.

This is a deal-breaker for Malcolm Finlayson, who runs Angstrom Pharmaceuticals a virtual company that is in phase II clinical trials with an ovarian cancer drug. Angstrom spends almost all of its money on outsourcing, he said.

However, he said all of his outsourcing is with companies based in the United States, so the grant money would satisfy the purpose of the grants, which is to create products and jobs in the United States.

“At some point this has to be addressed,” Finlayson said. “When is the SBA going to recognize that the virtual model is here to stay?”

The answer is not likely this year. Although the SBIR program has a reauthorization deadline of Sept. 30, the sense among those involved in the issue is that Congress will extend the reauthorization by at least three months while they hash out various issues.

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