Market Watch: Federal R&D program boosts small business values

The war in Iraq, even more so than Operation Desert Storm in 1991, is demonstrating the enormous impact of modern technology on U.S. defense policy and warfighting strategy. Our military branches and intelligence agencies are deploying cutting-edge technologies faster than ever before. Accordingly, those companies that engage in research and development and the follow-on prototyping, testing and production of technology products are critically important in sustaining our technological superiority. The federal government's recognition of the importance of technology is manifested in the Small Business Innovative Research (SBIR) Program. Participating companies are distinguished from their competitors by knowledgeable investors, savvy buyers and thoughtful customers. Clearly, these attributes suggest that company value differentials should exist.Companies that conduct research and development have the potential to produce disruptive technologies that dominate existing markets or, alternatively, create new markets with significant demand. Of course, R&D activities are highly speculative and frequently produce products without market potential or value. A large proportion of research and development activities are performed by small, highly entrepreneurial companies. Combining small company risk with the uncertainties of innovative research translates to scarce and expensive investment capital, particularly in down markets.More than 20 years ago, the federal government recognized the importance of sustaining R&D on its behalf. The SBIR program was formulated with the goal of increasing commercialization opportunities derived from federal R&D efforts. In 1982, Congress passed the Small Business Innovation Development Act, the public law that established the SBIR Program. In the ensuing 20 years, more than 60,000 projects worth more than $12 billion have been awarded.This program embodies a three-phase approach to technology funding. Phase I allows contract awards of up to $100,000 to evaluate a concept for its scientific or technical merit and feasibility. Phase II, with contract ceilings up to $750,000, provides funding for principal R&D around the concept set forth in phase I. Since 1982, about 25 percent of funding has supported phase I activities, with almost 75 percent of the funding consumed in phase II. In phase III, the tested prototype is produced. For products designed principally for government use, funding may be provided under government contract arrangements.Last year, Congress extended the SBIR Program to 2008. The phase III rights of SBIR research and development contractors also were strengthened. The government's policy directive clearly states that phase III contracts should be awarded, sole source, to the original phase I or II contractors. The policy directive implementing congressional requirements also makes it clear that data rights and ownership of intellectual property remain with the small business that invented the technology.These two factors can add substantially to the value of many small, high-technology R&D companies. To the extent that they produce valuable products, they can retain the rights to follow through in the production phase on a sole-source basis. Secondly, these technology rights will survive either the small business' growth into a large business or its acquisition by a large business.While many acquirers are wary of businesses with technology development initiatives, these R&D companies, properly managed, can provide significant discriminators in competitive procurements, either as a prime or critical subcontractor. The extension of the SBIR program ensures a continuing stream of small R&D firms, some of which will grow into larger, distinguished businesses, whether privately owned or publicly traded. And frequently, their shareholders and employees will be handsomely rewarded. *Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.