The Small Business Innovation Research Program

1
The Small Business Innovation Research Program

• ?
• Virginia Commercialization Workshop
• July 31, 2003
• Virginia Commonwealth University
• Richmond, Virginia
• Charles Wessner, Ph.D.
• Director, Innovation and Technology
• National Research Council

2
Presentation

• Government Support for RD in Industry
• Fostering Science-Based Growth
• Policy Myths and Market Realities
• Capital Market Imperfections
• U.S. Policies for Innovation-Led Growth
• Public Programs to Finance Entrepreneurs Small
  BusinessesSBIR
• Roles, Structure, Perspectives, Contributions
• The NRC Evaluation
• Conclusions

3
The U.S. National Academies
NAS

• The NRC is the Operating Arm of the National
  Academies, which includes the Board on Science,
  Technology, and Economic Policy (STEP)
• The NRC Mission is to Advise the Government and
  the Nation on Science, Engineering, and Medicine.

NAE
IOM
NRC
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Basic Research Recognized as Key to Sustained
Long-Run Growth

• Basic Research Underpins Science-Based Growth
• Basic Research is key in supplying a steady
  stream of fresh and new ideas
• Ideas if effectively transferred to the private
  sector, can become innovations
• With the right policy support, innovations can
  become commercial products driving growth
• Basic research is essential, but it is not
  enough!
• Developing incentives to spur innovative ideas
  for new products is a central policy challenge

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Significance of Pubic Support forEarly-Stage
Technology Development

• Early-Stage Technology Development
• Over time transforms nations portfolio of
  science engineering knowledge into innovations
• Generates new markets and industries
• Large returns to long-term economic growth with
  one relatively small national investment
• Branscomb Auerswald

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Government Support for RD in Industry A Key
Element in an Innovation System, but often
Controversial in the United States
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Precedents for Public Role in Science
Commercialization

• 1798 - Grant to Eli Whitney to produce muskets
  with interchangeable parts, founds first machine
  tool industry
• 1842 - Samuel Morse receives award to demonstrate
  feasibility of telegraph
• 1915 National Advisory Committee for
  Aeronautics instrumental in rapid advance in
  commercial and military aircraft technology
• 1919 - RCA founded on initiative of U.S. Navy
  with commercial and military rationale. Patent
  pooling, antitrust waiver and equity
  contributions.
• 1940s, 50s, 60s - Computers, Semiconductors,
  Satellites
• 1969-1990s - Government investment in forerunners
  of the Internet (Arpanet) Global Positioning
  Satellite
• Today Current investments in genomic/biomedical
  research

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Myths and Realities aboutGovernment Support of
Industry RD
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Charles W. Wessner, Ph.D.
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Policy Myths Market Realities

• The Myth of Linear Innovation
• The Myth of Military Spin-Offs
• The Myth of Perfect Markets
• The Myth of the Venture Capital Solution

Charles W. Wessner, Ph.D.
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The Myth of the Linear Model of Innovation

• Myth Innovation is a Linear Process

Basic Research
Applied Research
Development
Commercialization

• Reality Innovation is a Complex Process
• Major overlap between Basic and Applied Research,
  as well as between Development and
  Commercialization
• Many Unexpected Outcomes
• Principal Investigators and/or Patents and
  Processes are Mobile, i.e., not firm dependent
• Presence of feedback loops suggest that
  technological breakthroughs may precede, as well
  as stem from, basic research

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Non-Linear Model of Innovation

• Quest for Basic Understanding
• New Knowledge
• Fundamental Ideas

Basic Research

• Potential Use
• Application of Knowledge to
• a Specific Subject
• Prototypicalization

• Feedback
• Basic Research
• needed for discovery
• Search for new
• ideas and solutions to
• solve longer term
• issues

• New
• Unanticipated
• Applications

Applied Research

• Feedback
• Applied Research
• needed to design
• new product
• characteristics

• Development of Products
• Goods and Services

Development

• Feedback Market Signals/
• Technical Challenge
• Desired Product Alterations
• or New Characteristics
• Cost/design trade-off

Commercial- ization
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The Myth of Military Spin-Offs

• Myth U.S. Defense Research/Procurement Directly
  Funds Civilian Technologies
• Reality
• Very few technologies proceeded effortlessly
  from defense conception to commercial
  application.
  Beyond Spin-off, John Alic, Lewis Branscomb, et
  al.
• Efforts to use low-cost civilian technologies for
  defense use, i.e.,
  spin-ins, are often blocked by complicated
  military procurement system

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The Myth of Perfect Markets

• Myth If it is a good idea, the market will fund
  it.
• Reality
• Market participants have less than perfect
  knowledge, especially about innovative new ideas
• Asymmetric Information leads to suboptimal
  investments
• This means that it is hard for small firms to
  obtain funding for new ideas

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The Valley of Death Early-Stage Funding Gap
Capital to Develop Ideas
Federally Funded Basic Research Creates New Ideas
To Innovation
Applied Research Innovation
No Capital
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The Myth of U.S.Venture Capital Markets

• Myth U.S. VC Markets are broad deep, thus
  there is no role for government awards
• Reality Venture Capitalists have
• Limited information on new firms
• Prone to herding tendencies
• Focus on later stages of technology development
• Sharp Reduction in Available Capital
• Large U.S. venture capital market is not focused
  on early-stage firms

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Imperfections in the U.S. Innovation
SystemThe Current Collapse in Early-Stage
Finance

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VC Markets More Risk Averse
Source PriceWaterhouseCoopers/Venture
Economics/National Venture Capital Association
Money Tree Survey, 2003
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Breakdown of U.S. Venture Capital by Stage of
Development-2001
799 million
Total 41.284 billion
Source PricewaterCoopers, Venture Economics,
National Venture Capital Association, 2003
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Breakdown of U.S. Venture Capital by Stage of
Development-2002
302.8 million
Total 21.179 billion
Source PricewaterCoopers, Venture Economics,
National Venture Capital Association, 2003
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Average Deal Size Up Volume Down

• Disadvantages Start-up Firms

13.0
9.7
8.8
7.0
6.3
5.1
4.6
4.1
4.3

Year to Date
Source PriceWaterhouseCoopers/Thomson Venture
Economics/NVCA MoneyTreeTM Survey
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VC Investment Signs of Recovery

• THE WALL STREET JOURNAL, July 29, 2003

• Overall venture investing in Q-2 rose slightly to
  4.3 billion following 5-year low of 4 billion
  in Q-1 of 2003
• Number of IPOs Up
• Deal flow is improving
• Investors eager to see 70 to 80 billion in VC
  pipeline put to work
• Funding for Early Stage Companies Up 43 in Q-2

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But Turnaround is not ImminentTHE WALL STREET
JOURNAL, July 29, 2003

• "Is this a harbinger of a dramatic turnaround in
  venture capital investing? It's not likely."
• Mark Heesen, President,
• National Venture Capital Association.
• Q-3 investments are Typically Slower
• Little Fundraising Going On
• Investments in Biotechnology Medical devices
  account for 76 of Q-2 up-tick

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Challenges in the U.S. Innovation System Capital

• Institutional Role of Venture Capital in
  Early-Stage Finance is Limited
• Growth in Average Deal Size Works Against Small
  Firms
• Increased Risk Aversion by Institutional
  Investors Works Against New Innovations,
  especially those in small firms
• Trend in VC Finance is Negative

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U.S. Policies for Innovation-Led Growth

• An Enabling Environment

Charles W. Wessner, Ph.D.
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U.S. Entrepreneurial Environment

• A Key to Knowledge-Based Growth
• Sources and Limitations
• Drive for Ownership High Rates of Business
  Formation
• High Value placed on business success
• Low Regulatory barriers for entry
• Ease of company formation
• Pace of activity increases the effective value of
  capital
• Access to early-stage financingvery important
• Deep and Diverse Capital Markets Access to
  Capital
• Substantial Growth in VC Funding, very rapid in
  late 1990s
• Substantial Contraction since 2000trend is
  downwardsif stabilizing

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Positive Policy Framework

• Microeconomic Incentives for an Entrepreneurial
  Environment
• Intellectual Property Regime Incentive for
  Invention
• Tax Policy Incentive for High Risks
• Regulatory Policy Low Regulation for New
  Entrants
• Labor Flexibility Hire and Fire as Needed
• Public-Private Partnerships
• Innovation Awards
• Industry Consortia
• 3. Growing Role of Universities as Innovators
  Investors
• Enabling Policy Framework with Incentives for
  Professors and Universities
• Universities are (or have to become) more agile,
  more flexible, more diverse to encourage
  commercialization
• ST Parks growing in importance

• ST Parks
• University-Industry Cooperation

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U.S. Policies for Innovation-Led Growth
Public Programs to Finance Entrepreneurs and
Small Businesses
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Programs to Bridge the Valley of Death
Uncertainty and Distance to Market
Startup Friends, Families Fools
Strategic research Curiosity research Applied
research
Seed Angel Investors
The Financial Valley of Death The Focus of
Federal Innovation Awards
Federal Innovation Awards
Need for Supportive Policy Framework
Prototype Product development Commercialisation
1st Round VC
2nd Round VC
Capital Allocation Curve
Business development Investment
Expansion
Total Allocated Resources
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Role of Government in Early-Stage Technology
Development

• Markets for Allocating Risk Capital to
  Early-Stage Technology Ventures are not Efficient
• Most Early-Stage Funding comes from
• Individual private-equity Angel investors
• Corporations
• Federal Government
• Not Venture Capitalists!
• Federal Technology Development funds can
  Complement Private Funds
• More important than we thought

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Estimated Distribution of Funding Sources for
Early-Stage Technology Development
Branscomb Auerswald, Between Invention and
Innovation An Analysis of Funding for Early-Stage
Technology Development, NIST, 2002
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The Small Business Innovation Research Program
(SBIR)

• Addresses Very-Early-Stage Financing
• One Step on the Innovation Ladder

Charles W. Wessner, Ph.D.
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• The SBIR Program
• Created in 1982, Renewed in 1992 2001
• Participation by all federal agencies with an
  annual extramural RD budget of greater than 100
  million is mandatory
• Agencies must set aside 2.5 of their RD budgets
  for small business awards
• Currently a 1.6 billion per year program
• Largest U.S. Partnership Program

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SBIR Critical Source of Predictable Funding for
Early Stage Finance

• SBIRMain Source of Federal Funding for Early
  Stage Technology Development

SBIR

• SBIR over 85 of Federal Financial Support for
  Early Stage Development
• SBIR over 20 of Funding for Early Stage
  Development from all Sources

Estimate of Federal Government Funding Flows to
Early Stage Technology DevelopmentBased on total
funding for ATP, SBIR STTR programs by
Branscomb and Auerswald 2002
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Roles of SBIR

• Stimulate Innovation
• Introduces qualified Small Businesses into the
  Nation's RD Arena
• Achieve National Missions
• Applies Imagination and Ingenuity of Small Firms
  to Address National Needs
• Stimulate GrowthSmall Businesses are a Major
  Source of Innovation and Jobs
• Meet Nations Specific Research and Development
  needs by Harnessing Entrepreneurial Spirit
• Draw Private Capital to Promising Firms
• SBIR Award Reviews Signal Scientific and
  Commercial Value of Firms Innovation
• Overcome Small Firm Disadvantage in Access in
  Federal Contracts
• Small firms do not have the Resources to Monitor
  and Influence Agency decisions on Procurement
• SBIR helps Small Firms Access the Government
  Procurement System, Bypassing Complex Regulations

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SBIR-University Nexus can Promote Local Economic
Growth

• Technology TransferSBIR, a bridge to help bring
  University Research to the Market
• Initiative for professors to start firms to
  exploit commercial potential of laboratory
  findings
• From software to molecules to rat cages
• Vehicle for Collaboration between Local Firms and
  University Departments
• E.g. Sensors Unlimited and Princeton University
  collaboration on Optoelectronics research
• Princeton had the facilities, Sensors Unlimited
  had the engineers
• Validates Research of Professors
• The Porsche Effect attracts students
• Commercial Outcomes from Research

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SBIR

• Common 3-Phase Approach
• Commendable Flexibility in Administration

Charles W. Wessner, Ph.D.
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• SBIR 3-Phase funding approach
• Phase I or Feasibility Phase
• Competitive award of limited federal research
  funds for short-term investigation of scientific
  merit and feasibility
• Up to 100,000 in funding
• Normally up to 6 months to complete the first
  phase
• Highly Competitiveonly 12 to 14 of submitted
  proposals receive Phase I awards

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• SBIR 3-Phase funding approach
• Phase II or Prototype Phase
• Selection emphasizes research projects with
  strong scientific merit and strong commercial
  merit
• Maximum award level of 750,000
• Sometimes more, e.g., for drug development
• Typically restricted to two years for completion
• Still Competitive
• Only 40 of Phase I firms receive Phase II awards

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• SBIR 3-Phase funding approach
• Phase III or Commercialization Phase
• No additional SBIR program funding
• Federal agencies can provide procurement funds,
  but the agency must finance Phase III using
  non-SBIR funds
• Intent Product development and
  Commercialization arising from Phase II projects

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SBIR Goals Vary Among Agencies

• Multiple Program Goals
• Commercialization and Research
• Multiple Agency Goals
• NIH
• Research Tools, Medical Devices, Drug
  Development, and Audio-Visual Health Materials
• DOD
• Special Forces Equipment
• Neural Network Processors for remotely piloted
  jets
• Wireless Communications for Divers
• Low-cost, High-performance Drones

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SBIR Differs Among Agencies

• Multiple Administrative Systems
• Each agency typically has its own manner of
  choosing awardees and screening applications
• Different metrics reflecting unique agency
  missions and needs
• Different Metrics by industrial sector, e.g.,
  software vs. drug development vs. weapon
  components
• Commendable Flexibility Diversity

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Flexibility in the Program

• Department of Agriculture
• Smaller Program, Smaller Awards
• Phase I 30,000 to 60,000
• Focus on Regional Development
• National Institutes of Health
• Larger Programs, Larger Awards
• Large Programs (e.g. Drug Development) can
  receive funding up to 3 million over 3 years
• Department of Defense
• By the book--Phase I 100 million
• Phase II 750 million
• But DoD can add procurement funds

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SBIR

• Perspectives
• Contributions

Charles W. Wessner, Ph.D.
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Common Criticisms of the SBIR Program

• Crowding Out of Private Capital
• The program encourages the funding of marginal
  firms and replaces private capital
• Selection Bias
• Selected firms would have done as well without
  SBIR award
• Low Commercial Rates of Return
• Results are highly skewed Few firms succeed

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Common Criticisms of the SBIR Program

• Set AsideA tax on RD budgets
• The program interferes in the effective
  management of agency RD by favoring a sub-set of
  companies
• High Paperwork Funding Ratio
• Involves too much paperwork for relatively little
  funding6 reports in 6 months for 100K
• Program Capture
• Presence of multiple award winners with many
  awards but little commercialization
• Targeted awards for pet projects

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An Analytical Perspective

• Few firms succeedbut with high pay-backs
• Crowding out of private capital seems doubtful
• Empirical evidence of systematic crowding out is
  absent (David, Hall, and Toole 2000)
• Crowding in does occurawards attract private
  investors (Feldman Kelly 2000)
• Venture Capitalists tend not to invest upstream
  (David Morgenthaler, Morgenthaler Venture
  Capital)
• SBIR is not a public venture capital program
• Lerner 1999
• Why not?
• No equity ownership ? No loss of control
• No management input ? No exit strategy

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An Analytical Perspective

• Claims that firms would have succeeded in any
  event overlooks two important functions of SBIR.
  
• SBIR develops and signals information about firm
  potential, improving the information available to
  private investors.
• Second, SBIR awards can motivate a researchers
  decision to start a firm. (Audretsch et al, 2002)
• No empirical evidence of Selection Bias as a
  problem in SBIR awards
• (Jaffe, 2003)

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SBIR Projects Attract Sales Investment

• DoD Believes Most Firms Successfully Transition
  Hi-Tech Research to Commercialization

• 57 of Firms With Recent Phase II DoD Projects
  (1994-1999) Have Sales and/or Investment

Investment
Sales
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Contributions of SBIR

• Catalyzes the Development of New Ideas and New
  Technologies
• Capitalizes on Substantial U.S. RD Investments
• Addresses Gaps in Early-Stage Funding for
  Promising Technologies
• Certification EffectGovernment Endorsement of
  Technical Quality Attracts Private Capital

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Contributions of SBIR

• Provides a Bridge between Small Companies and the
  Agencies, especially for Procurement
• Contributes New Methods and New Technologies to
  Agency Missions
• Provides a Bridge between Universities and the
  Marketplace
• Encourages Local and Regional Growth,
  increasingly through the University Connection
• An Interesting Program Not Well Understood

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Evaluating SBIR

• The NRC Assessment

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Charles W. Wessner, Ph.D.
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The Role of Analysis

• Program and Project Analysis are Essential to
• Clarify program goals and objectives early on
• Develop meaningful metrics
• Generate measurable definitions of success
• Contribute to a better appreciation of the role
  of partnerships among government, university, and
  industry
• Help inform public and policy makers of the
  opportunities, benefits, and risks involved in
  public-private cooperation

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Evaluation Challenges

• Counterfactual
• Was the commercialization or its timing caused by
  the SBIR award?
• It is not sufficient to observe that an SBIR
  award was made and later that the awardee
  commercialized a new product.
• Selection Bias
• What is the extra impact of the award on firm
  performance?
• Firm-Based Surveys or Project-Based Surveys?
• What data is available? How is it organized?

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SBIR is Under-Evaluated

• Limited Academic Analysis
• Program too big, topic too important
• Limited Government Analysis
• Reviews are anecdotal
• Most internal reviews are never released
• Most Agencies Have Limited or No External
  Assessment
• First NRC Analysis Recommended More, and More
  Regular, Assessment

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New Multi-Year, Multi-Agency NRC Study of SBIR

• Congress Agreed and requested the NRC review the
  5 largest agencies that account for 97 of the
  programs funding in 2003
• Department of Defense
• National Institutes of Health
• Department of Energy
• National Aeronautics and Space Administration
• National Science Foundation
• 5 million, 3-year study

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Proposed Evaluation Techniques

• Surveys
• Phase I Recipient Survey
• Phase II Recipient Survey
• Program Manager Survey
• Technical Manager Survey
• Case Studies
• Directed to company officers and individual
  research scientists as well as to research
  managers within the funding agency.
• Purpose
• To generate detailed data not accessible through
  surveys
• To pursue lines of inquiry suggested by surveys
• To identify anecdotes that illuminate findings

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Evaluating SBIR

• Compared to What?
• Competitive Awards Not Subsidy
• Early Stage Finance Higher Risk
• High Skew is Normal
• Greatest Returns from Few Investments
• VC Comparable?
• Compared to RD Tax Credits?

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Innovation Awards vs. Tax Credits

• RD Tax Credits are often too Broad in
  Application
• Cost is too High Compared to Innovation Awards
• Incentive Effect of Tax Credits Depends on
  Revenue
• Small Innovation Firms often Have no Revenuethus
  Tax Credits provide Little Incentive
• Tax Credits can Help Established Businesses
• Additional Impact of Tax Credit Hard to Calculate
• Effectiveness of Tax Credits compromised by
  history of repeated, limited extensions
• National Association of Manufacturers

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Innovation Awards vs. Tax Credits

• Innovation Awards are
• Targeted on Specific Outcomes
• Higher Impact at Lower Cost
• Targeted at Critical Juncture in the Innovation
  System
• Valley of Death
• Effective and Flexible
• PowerfulLeverages Resources
• Conditionalwork can be stopped
• Industry-driven
• Less bureaucratic
• Closer to market
• More take up of technologies

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Conclusions
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Sustaining Science-Based Growth

• Generating Science-Based Growth is a Major Policy
  Interest around the World
• Not Enough is Known about Early-Stage Finance
• The Linear Innovation Model Needs Help!
• Inputs for more research are not enough
• The process of ideas to innovations to products
  can be improved with awards to small business
  innovation

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SBIR Broader Policy Implications

• Small Business is Instrumental in Bringing the
  Benefits of University Research to the
  Marketplace
• Small firms employ the Majority of the Workforce
  while contributing to Economic Growth
• The SBIR addresses Key Elements of the National
  Innovation System and is therefore of Central
  Policy Interest.

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• END
• Charles W. Wessner, Ph.D.
• Board on Science, Technology, Economic Policy
• National Research Council
• 500 Fifth Street NW
• Washington DC 20001
• cwessner_at_nas.edu
• Tel [phone]
• http//www.nationalacademies.org/step