GW Law Faculty Publications & Other Works Faculty Scholarship

2011

Venture Capital Investment and Small Affiliation Rules: Why a Limited Exception is Crucial to Economic Recovery Efforts

Jessica Tillipman George Washington University Law School, [email protected]

Damian Specht

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Recommended Citation Jessica Tillipman & Damian Specht, Investment and Small Business Affiliation Rules, Contract Management, Feb. 2011 at 30.

This Article is brought to you for free and open access by the Faculty Scholarship at Scholarly Commons. It has been accepted for inclusion in GW Law Faculty Publications & Other Works by an authorized administrator of Scholarly Commons. For more information, please contact [email protected]. Venture Capital Investment and Small Business Affiliation Rules

BY Jessica Tillipman and Damien Specht

30 Contract Management | February 2011 Why a limited exception is crucial to economic recovery efforts.

Contract Management | February 2011 31 Small and venture capital are a natural pair. While many small businesses are born of technical expertise and innovation, few are well financed. One of the reasons for this lack of financing is that small concerns are often viewed as risky investments. Small businesses are rarely led by experienced business people and, as many statistics demonstrate, are more likely than not to fail.1

Unlike their underfinanced counterparts, that, while well intended, have the effect of remain well equipped to aid small concerns4 venture capital companies (VCCs) are well holding back promising small businesses in and their assistance is imperative.5 As a financed and what they lack in technical the federal marketplace. In this harsh eco- result, now is the time to advance a compro- capability, they make up for in business acu- nomic climate, venture capital is crucial to mise position that protects small business men and financial wherewithal. Moreover, small, innovative businesses. Although VCCs programs while encouraging venture capital risky investments with large upsides are have felt the impact of the recession, they investment in federal contractors. exactly the type of opportunities that can produce significant returns for venture capital funds.

In the commercial marketplace, many small businesses receive venture capital infusions to transform their ideas and research into viable products.2 This same principle should apply to federal procurement, where U.S. government procurement policies favor small contracting, but early-stage research and development funding is difficult to come by. VCC investment should be utilized to fill the gap between government policy and economic reality by supporting early- stage funding for small businesses. This type of investment would increase the pool of po- tential small businesses for federal procure- ment and help to diversify the government’s contractor portfolio resulting in a positive impact on a fundamental tenet of govern- ment procurement: competition. There are technological benefits as well. With the assistance of venture capital investments, small companies would have the freedom to develop cutting-edge technologies for the federal government which larger, more established may be either unwilling or unable to develop.3

However, the mutually beneficial relation- ship between small business contractors and VCCs has been frustrated due to a complicated web of government regulations

32 Contract Management | February 2011 Venture Capital Investment and Small Business Affiliation Rules

Affiliation company’s size status by adding together very fact-specific. In cases where the small Federal agencies are encouraged to set the employees and of related firms. business is not majority owned by a single aside contracts for small businesses. These More often than not, this analysis results in investor, SBA regulations note merely that set asides limit competition to small a determination that changes a company’s it will examine the “totality of the circum- businesses based on employee- or revenue- size status from small to “other than small” stances” to determine if two (or more) based metrics.6 Standing alone, the small without any actual change in that firm’s businesses should be considered affiliated, businesses that receive venture capital employee count or . and thus a single entity.8 The regulations investment are, in fact, “small” as mea- do, however, list some factors that, when sured by employees or revenue. Similarly, Affiliation is particularly relevant to the present, increase the risk of two businesses venture capital firms are often, at least by small business/venture capital relationship being found to be affiliated. These factors number of employees, thinly staffed small because SBA frequently finds VCCs to be af- include: businesses. However, many small business- filiated with not only a single small business, es that receive investments from similarly but also with the other portfolio businesses ƒƒ Control, small VCCs are deemed to be “large,” and, in which they invest.7 This concept is vital as a result, ineligible for set-aside awards by for small businesses and venture capital ƒƒ Ownership, the Small Business Administration (SBA). If investors to understand because once a both VCC firms and their investment targets small firm is deemed affiliated with a VCC, it ƒƒ Management, and are small, why is there a barrier to investing will often exceed SBA’s size standards, lose in small businesses that perform set-aside its small business size status, and can no ƒƒ Contractual relationships.9 contracts? The answer is “affiliation.” longer compete for set-aside work. This is likely to make the business a less profitable When VCCs invest in small businesses, the Affiliation is a concept developed to prevent enterprise and a less attractive investment. “control” factor often results in a finding of small firms that are closely related to large affiliation. Most VCCs require some level of firms from being awarded small business How does SBA calculate affiliation? The control as a condition of their investment contracts, and requires SBA to analyze a answer is not entirely clear and is generally in a particular company. However, because

Contract Management | February 2011 33 Venture Capital Investment and Small Business Affiliation Rules

of a business’s voting , SBA may make the counterfactual presumption that both individuals or entities control or have the power to control a small business.15 One ca- veat to this is that if a business’s voting stock is widely held and no single block of stock is “large” (when compared with all other holdings), the business’s board of directors and CEO or president will, in the absence of evidence to the contrary, be deemed to have the power to control the business.16

Control and affiliation may also be attrib- uted to individuals who do not own stock in a particular concern.17 For example, VCC investors will often require that employees of a particular fund serve on the board of portfolio companies. This is risky because SBA will find two concerns to be affiliated when one or more officers, directors, or general partners of one concern control the board of directors and/or the management of one or more other concerns.18 A further twist on this concept is that interests may be combined based on “identity of interest.” Individuals with an “identity of interest” affiliation may be found when individuals or firms that have identical or substantially identical business or economic interests (such as family members, individuals or firms with common investments, or firms that are economically dependent through contractual or other relationships) are treated as one party because such interests are aggregated.19 This determination may be rebutted with evidence that demonstrates the interests are separate.20

Another complication is that control can be either “affirmative” or “negative.”21 small business set asides minimize competi- Typically, a VCC will be found to control, and Affirmative control is straightforward and tion, these same investors would prefer that thus be affiliated with, a platform business will be found by SBA if, for example, the VCC the target small business retain its status. through stock ownership.12 Stock ownership owns the majority of voting stock, controls There is, therefore, a constant struggle may lead to affiliation under a variety of cir- the board of directors, or if VCC approval is to strike an appropriate balance between cumstances, including when an entity owns necessary before the company can make protecting an investment without triggering a block of stock that is larger than other certain business decisions.22 Negative the “control” factor and jeopardizing the outstanding blocks of voting stock.13 That control, on the other hand, involves more small business’s size status.10 Complicating said, ownership of less than 50 percent of the subtle factors and may be challenging for this issue further is the fact that, for the voting stock of an entity is not a safe haven VCC investors that rely on indirect methods purposes of affiliation, it does not matter from affiliation.14 Rather, if two or more to protect investments in portfolio compa- whether control is exercised, as long as the individuals or entities own, control, or have nies. SBA’s regulations provide that a con- power to control exists.11 the power to control less than 50 percent cern has negative control and is affiliated

34 Contract Management | February 2011 Venture Capital Investment and Small Business Affiliation Rules

when, “though lacking affirmative ability ings of affiliation, most have failed. For owned 74 percent of the contractor’s stock to approve actions, it can block corporate example, many VCCs have argued that they and characterized itself as an “investment action by the other concern.”23 In determin- are exempt from affiliation based on the entity” without an active role in the man- ing whether a concern has negative control exception found at 13 C.F.R. §121.103(b)(5) agement or operation of the contractor’s over another concern, SBA considers the (i) “for venture capital operating companies business.30 SBA determined that the holding following factors: (VCOCs) that provide financial, management, company was an affiliate for purposes of or technical assistance under the Small SBA size determinations, basing its finding, ƒƒ Whether the affiliate has veto power, Business Investment Act of 1958.” This argu- in part, on the fact that the regulations ment has repeatedly failed because SBA’s consider an entity “affiliated” if it controls ƒƒ Can block or deadlock the board’s ac- regulations explicitly limit the exception to or has power to control 50 percent or more tions, or “VCOCs,” as defined by the Department of of the contractor’s voting stock.31 Labor regulations.26 ƒƒ Can prevent a quorum at the share- The affiliation rules place VCCs in a difficult holder or board of directors meetings. VCCs have also argued that their passive position. By their nature, VCCs not only “control” in a small business does not con- invest but want to participate to varying de- SBA will also address the size of the other stitute affiliation, but this claim has been grees in the management of their portfolio blocks of stock, whether there are any repeatedly rejected by SBA.27 According to businesses.32 A VCC cannot own a majority agreements that limit the amount of control SBA, it is not relevant that VCCs are passive of the small concern’s stock or assume a the affiliate has over the concern,24 and the investors if they have the potential to con- majority position on the board of a small number of directors the alleged affiliate has trol a small business.28 For example, in Size government contractor, however, because on the board.25 Appeal of TSP TWO, Incorporated, the con- of the risk that a target small business will tractor argued that it was not affiliated with be found affiliated with the company and While many venture capital firms have two different companies—one of which was each of its portfolio businesses. Moreover, raised creative arguments to avoid find- a holding company.29 The holding company under SBA’s current interpretation of its

Contract Management | February 2011 35 Venture Capital Investment and Small Business Affiliation Rules

regulations, VCCs cannot safely install like the current affiliation principles, this the ability of small businesses to obtain market-standard negative covenants legislation indicates that affiliation in some capital without impacting their size status. without risking a negative control finding. circumstances may be narrowly tied to This means companies must forgo venture This regulatory strait jacket is a significant stock ownership and seats on the board of capital financing or risk losing eligibility to impediment to investment, which limits directors. The other factors of affiliation, compete for small business set aside con- the growth of small businesses involved in including negative covenants and manage- tracts and subcontracting opportunities government contracting.33 ment control, are notably absent from the with prime contractors who seek to meet language of the bill. Although this legisla- small business subcontracting goals. As a tion does not apply to all small businesses, result, some of the most innovative small Current it does indicate congressional intent that, businesses are disqualified from participat- Legislative for SBIR participants receiving specific types ing in federal programs simply because and Executive of venture capital funding, many of the af- they receive no venture capital funding. Initiatives in filiation factors may soon no longer apply. Support of A close read of the Small Business Invest- Venture Capital The Obama administration has also made ment Act of 1958 makes it difficult to under- Recent legislative changes proposed by Con- statements that signal its support of ven- stand why SBA has failed to exempt VCCs gress and statements made by the Obama ture capital. The administration has stated from affiliation. Specifically, Section 103 of administration suggest a more favorable that it plans to improve the procurement the statute states: view toward the small business/venture system to attract venture capital–backed capital relationship. On the legislative front, companies39 and increase minority-owned [A]n investment by a venture capital firm... Congress has proposed amendments to business access to venture capital. In addi- (i) shall not cause a business concern to the Small Business Act that would permit tion, the president has appointed individuals be deemed not independently owned and VCCs to invest in small businesses with- with venture-capital backgrounds to several operated regardless of the allocation of out triggering affiliation.34 The proposed key positions; two such examples include control during the investment period under amendments apply to small businesses that SBA appointees Karen Mills and Winslow any investment agreement between the participate in the Small Business Innovation Sargeant.40 These appointments indicate business concern and the entity making Research (SBIR) program. The SBIR program the administration’s support for venture the investment; (ii) shall be disregarded in ensures that small, high-tech, innova- capital. Indeed, Sargeant has specifically determining whether a business concern tive businesses receive a significant portion voiced his support for the inclusion of ven- satisfies size standards established pursuant of the federal government’s research and ture capital investments in SBIR partici- to section 3(a)(2) of the Small Business Act; development funds.35 Current SBIR regula- pants.41 These factors, while not dispositive, and (iii) shall be disregarded in determin- tions require participating small businesses imply the administration holds a favorable ing whether a small business concern is a to be at least 51-percent owned and con- view toward the role of venture capital in smaller enterprise... trolled by “natural persons” who are either the procurement system. U.S. citizens or permanent resident aliens of The plain language of this provision appears the United States36; or, at least 51-percent to expressly exempt VCC-owned concerns owned and controlled by another business Affiliation from affiliation rules. concern that is at least 51-percent owned Regime and the and controlled by “natural persons” who are Negative Impact Created by Congress in 1953, SBA is tasked either U.S. citizens or permanent resident on Venture primarily with the role of aiding, counseling, aliens of the . Capital assisting, and protecting the interests of There is no doubt that the current econom- small business concerns.43 In other words, The SBIR/STTR Reauthorization Act of 2009 ic climate has made it difficult for small “SBA helps Americans start, build, and grow included proposed amendments to affilia- businesses to raise capital from and businesses.” Contrary to its founding prin- tion designed to encourage venture capital other lenders.42 In the federal marketplace, ciples, however, SBA’s affiliation rules impair investment in small businesses.37 Specifical- this tightening has been exacerbated by the ability of small businesses to obtain cap- ly, the legislation provided that a business the fact that the small business contrac- ital.44 Specifically, when small government concern would not be considered affiliated tors who are able to locate venture capital contractors obtain capital infusions from with a VCOC if the VCOC owns less than 50 financing are penalized for that support. VCCs, the investment is likely to change the percent of the business and employees of Despite recent initiatives that support business’s size status to “other than small” the VCOC do not constitute a majority of venture capital investments in small con- under SBA size standards.45 This new size the concern’s board of directors.38 Un- cerns, the current legislative regime limits status may result in the loss of government

36 Contract Management | February 2011 Venture Capital Investment and Small Business Affiliation Rules

contracts that have been set aside for small small business loses its attraction when its demonstrated significant market potential businesses or those in which the agency size status and its size-dependent contracts and received VCC funding. Well-meaning requires performance by a small business are lost. This result is in direct contraven- but misapplied small business regulations in order to satisfy its small business goals.46 tion of SBA’s policy goals: it harms rather have the practical effect of eliminating small Moreover, the loss of size status makes the than protects small business interests. businesses that receive VCC backing from business less attractive to prime contrac- competing for small business contracts, and tors interested in the concern only to satisfy forces the small businesses to compete their small business subcontracting goals. A Proposal for against large corporations for contracting op- This not only eliminates the small business’s Change portunities. Given that small businesses can- prime contracting opportunities, but also The government currently excludes most not compete on the same level as their larger its subcontracting opportunities. VCC-backed small businesses from competing corporate counterparts, such as Lockheed for small business contracting opportunities, Martin or General Dynamics, Although SBA claims the affiliation rules are regardless of their potential to provide high- the small concerns are likely to lose these designed to protect the interests of small quality products, services, and solutions. procurement opportunities and the govern- businesses, when VCC investments are It is at best illogical that the government ment will lose out on new and advantageous involved, the result is to the contrary. The penalizes small businesses because they have business .

Contract Management | February 2011 37 Venture Capital Investment and Small Business Affiliation Rules

Despite their shortcomings, SBA’s affilia- with a blanket exception to affiliation. an offeror must be the manufacturer of tion rules should not be eliminated entirely This solution would permit the partici- the end item.48 SBA may waive non-manu- because they serve an important purpose. pation of a VCC-backed small business, facture rule requirements if it “determines The government has an interest in ensuring regardless of the percentage of the that no small business manufacturer or that the small businesses which receive business controlled by a VCC. This type processor of the product or class of prod- set-aside contracts are, in fact, small busi- of waiver would, however, allow VCCs ucts is available to participate in the fed- nesses. Moreover, the government must the unfettered ability to create a series eral procurement market.”49 These waivers ensure that legitimate small businesses are of business fronts to compete for small are specifically tailored to select North not forced out of the federal marketplace by business set-asides. Large businesses American Industry Classification System large businesses using small business fronts. could also create private funds and (NAICS) codes where SBA has determined The affiliation rules, while clearly over-in- use these funds to access set-aside work. that there are no small business manu- clusive, are effective in preventing this type Neither of these scenarios, however, does facturers. This waiver process takes place of activity. At the same time, the current anything to inspire entrepreneurs to start largely in public, with notices required affiliation rules are holding many small small businesses, encourage innovation, to be published in Commerce Business businesses back from Daily and the Federal their potential and are Register before they limiting the types of are granted.50 Further, innovate goods and these waivers are not services that can be granted and forgot- offered to the federal ten. Rather, “non- government. manufacture rule” waivers are subject to To remedy this prob- challenge by private lem, the government individuals and are must revise existing periodically reviewed legislation and regu- by SBA.51 lations to eliminate un- reasonable restrictions A similar public process on VCC-backed small could be created with business concerns regard to waiver of while maintaining a the affiliation rules regulatory regime that for VCCs. This system protects all small busi- would have clear nesses. While encour- benefits over both aging VCC investment, current affiliation rules an effective proposal and an overall affilia- cannot have the effect tion waiver. Affiliation of squeezing out small businesses that lack or promote small business growth. Rather, waivers would be limited to NAICS codes such financing.47 Rather, the solution that an unlimited VCC affiliation waiver would in which SBA determines that the class of we propose attempts to strike a balance squeeze independent small businesses out product or service requires significant capi- between these opposing positions. While of government contracts, and consume tal investments that would not be possible there may be no perfect balance, regulatory available venture capital. without venture capital involvement. For reform focused on updating the concept of example, the venture capital community affiliation may provide venture capital ac- A more nuanced approach, modeled after often argues that there should be a blanket cess while maintaining the independence of waivers of the “non-manufacture rule,” affiliation waiver for all VCCs because some small businesses. This balance, particularly would have a more salutary effect on industries, such as biotechnology, require during the current economic downturn, will the type of venture capital activity small significant startup capital that is unlikely provide much needed capital and spur small businesses so desperately need while not to be available from traditional sources. business growth. foreclosing federal contracting opportuni- While a blanket affiliation waiver would be ties. Under the “non-manufacture rule,” over-inclusive, a specific waiver for biotech- One way to optimize venture capital in order to qualify as a small concern for nology-related NAICS codes would increase involvement in small business government a small business set-aside or an 8(a) con- access to venture capital funding while contracts is to provide VCC companies tract to provide manufactured products, limiting crowding out of small businesses

38 Contract Management | February 2011 Venture Capital Investment and Small Business Affiliation Rules

6. See 13 C.F.R. §121.201 (listing size standards). in other less capital intensive industries. In while still remaining eligible to compete for 7. See, e.g., Size Appeal of: Novalar Pharmaceuti- addition, these waivers have the benefit small business contracts. CM cals, Inc., SBA No. SIZ-4977 (2008). of being the result of public notice and 8. 13 C.F.R. §121.103(a)(5); 13 C.F.R. §121.103(a) comment, which will allow small businesses (5) (2010); Size Appeal of: Lance Bailey & Associ- to directly impact the waiver process. The ates, Inc., SBA No. SIZ-4817 (2006) (“Affiliation waivers, once granted, would be subject to About the Authors through the totality of the circumstances means that if the evidence is insufficient to periodic review to determine if significant JESSICA TILLIPMAN is the assistant dean for show affiliation for a single independent factor venture capital involvement is still required. outside placement and a professorial lecturer (13 C.F.R. §121.103(c), (d), (e), (f), or (g)), the SBA may still find the businesses affiliated Independent small businesses working in law at the George Washington University under the totality of the circumstances where under specific NAICS codes could also chal- Law School. the interactions between the businesses are so lenge existing waivers as traditional funding suggestive of reliance as to render the busi- nesses affiliates.”). In Lance Bailey, the court becomes available. DAMIEN SPECHT is an associate in the made clear, however, that “totality of the cir- Washington, DC, of Jenner & Block, LLP. cumstances is not an independent basis of affil- With a NAICS code–based affiliation waiver, iation” and that the “independent bases of affiliation…are the nucleus of a finding of affili- VCCs would have the freedom to take a The authors would like to thank Morgan ation through the totality of the circum- majority stock position in small businesses. Cosby and Anna Sturgis for their invaluable stances.” (Ibid.) VCCs could also impose affirmative and assistance in the preparation of this article. 9. See 13 C.F.R. §121.103. negative controls, which are central to 10. Venture Impact, The Economic Importance of protection of their investment in risky small Send comments about this article to Venture Capital-Backed Companies to the U.S. businesses. These incentives, coupled with [email protected]. Economy (HIS Global Insight, fifth ed.) (“Typi - cally, VCs take seats on the boards of their the ability to compete for small business portfolio companies and participate actively in set-asides, have the potential to increase firm management.”). venture capital involvement in areas where 11. 13 C.F.R. 121.103(a)(1); see also Pine Products Corp. v. U.S., 19 Cl.Ct. 691, 695–96 (1990) (dis- capital is key—especially during this time of Endnotes cussing how the control factor is applied to economic downturn. 1. See U.S. Small Business Administration, “Get joint ventures). Ready,” available at www.sba.gov/smallbusi- 12. 13 C.F.R. §121.103(c). nessplanner/plan/getready/SERV_SBPLAN- NER_ISENTFORU.html (explaining that 13. For example, when a person, business, or Conclusion “Starting a small business is always risky, and entity owns, or has the power to control, 50 In this harsh economic climate, small the chance of success is slim. According to the percent or more of a small business’s voting businesses need assistance to weather the U.S. Small Business Administration, roughly stock, the two concerns will be found to be 50% of small businesses fail within the first five affiliated. (13 C.F.R. §121.103(c)(1).) rough financial storm and VCC firms bring years.”). 14. See Size Appeal of: Forterra Systems, Inc., SBA managerial, technical, and financial exper- 2. National Venture Capital Association, The U.S. No. SIZ-5029 (2009). Small Business Administration’s Impact on the tise to their portfolio companies without 15. If these minority holdings are equal or approxi - Future of Government Funded Innovation, avail- managing the day-to-day operations of mately equal in size, and the aggregate of able at www.nvca.org/index. these holdings is “large,” as compared with small concerns. The beneficial nature of this php?option=com_docman&task=doc_ other stock holdings, SBA will find control. See download&gid=226&Itemid=93. relationship should not be hampered by a Size Appeal of Forterra Systems, Inc., Ibid. flawed regime based on absolutes which 3. Ibid. 16. 13 C.F.R. §121.103(c)(3); see also Size Appeal of: excludes VCC-backed small businesses from 4. See Peter Schnitzler, “The Recession’s Domino Eagle Pharm., Inc., SBA No. SIZ-5023 (2009). small business contracting opportunities. Effect,” Indianapolis Business Journal (May 11 The three largest blocks of stock are: Investor Nydia Velazquez, co-chair of the House 2009), available at www.allbusiness.com/ 1: 35.7 percent; Investor 2: Block which aggre- economy-economic-indicators/economic-con- gated totals 34.5 percent; and Investor 3: 7.2 Small Business Committee, said it best ditions-recession/12347516-1.html: “With less percent. Appellant’s ownership structure when she stated: “small firms must not be money available at the source, professional would quickly run afoul of the multiple-largest penalized for accepting investment they venture capitalists are hanging on to what minority shareholder rule, because the [Inves - they’ve got. And their priorities are changing. tor-1] and [Investor-2] Block holdings would be 52 need to advance their R&D efforts.” Rather than take risky bets on promising new “equal or approximately equal in size” and their technologies, [VCCs] are hunkering down, aggregate would be “large as compared with An exception to the affiliation rules must be trying to make the most of what’s already in any other stock holding.” Company tries to their coffers.” Still, although VCCs may be less argue widely held rule applies. Court dismisses made for VCC-backed firms if small busi- likely to invest in risky projects, they have a the argument, though the Investor 2 block con- nesses are to succeed in the current market. unique ability to adapt to circumstances and sists of over 20+ shareholders, this is not the definition of “widely held.” While a blanket exemption is not neces- will be a much relied-upon source of revenue for small businesses. sary, limited exemptions based on a firm’s 17. 13 C.F.R. §121.103(e). 5. See Pankaj Patel and Rodney D’Souza, “Uncov- 18. Ibid. particular service or product is more than ering Knowledge Structures of Venture Capital warranted. This solution will allow small Investment Decision Making,” Office of Advo- 19. 13 C.F.R. §121.103(f); see also Size Appeal of: Taylor Consultants Inc., SBA No. SIZ-5049 (2009). businesses to obtain much-needed capital, cacy Working Paper, available at www.sba. gov/advo/research/rs315.pdf. 20. Ibid.

Contract Management | February 2011 39 Venture Capital Investment and Small Business Affiliation Rules

21. 13 C.F.R. 121.103(a)(3); see also Pine Products 32. “Venture Impact, The Economic Importance of Corp. v. United States., 19 Cl.Ct. 691, 695–696 Venture Capital-Backed Companies to the U.S. (Cl.Ct., 1990) (explaining how control and affili- Economy” (HIS Global Insight, fifth edition) ation apply to joint ventures). (“Typically, [VCCs] take seats on the boards of their portfolio companies and participate 22. However, see Size Appeal of: Cytel Software, actively in firm management”). Inc., SBA No. SIZ-4837 (2007) (The SBA Board determined that though the VCC had a role in 33. See Keric B. Chin and Richard J. Vacura, “Small appointing three people on the board, that Business: SBA Rules to Continue to Impact Abil- alone did not result in negative control). ity of Small Businesses to Raise Capital,” BNA’s Federal Contracts Report Analysis & Perspective 23. Though a concern does not possess a specific (August 25, 2009), available at Westlaw, 92 talisman of control, like the majority of voting FCR 152 (discussing factors investors should stock, it controls the alleged affiliate because consider when making investment, including: the business “is not entirely free to conduct its percent of ownership; the implications of business as it chooses.” See Size Appeal of: shareholder voting agreements, corporate Regent Mfg., SBA No. SIZ-4533 (2003). charters, and bylaws; common management; 24. 13 C.F.R. 121.103(a)(3); see also Size Appeal of: and mutual business or economic interests. Eagle Pharm, Inc., SBA No. SIZ-5023 (2009) There are no bright lines or clearly delineated (finding negative control when a stockholder safe harbors to guide small businesses and investor could block payment of dividends and investors). creation of debt); Regent, Mfg, Inc., SBA No. 34. See SBIR/STTR Reauthorization Act of 2009, SIZ-4533 (2003). (Although not a VCC case, SBA H.R. 2965, 111th Cong. (as passed by the found negative control when a board required House on July 8, 2009, and Senate on July 13, the concurrence of all board members in order advances the views, concerns, and interests of 2009). to appoint an independent member.) However, small business before Congress, the White see Size Appeal of: EA Eng’g, Sci., & Tech., Inc., 35. See www.sba.gov/aboutsba/sbaprograms/ House, federal agencies, federal courts, and SBA No. SIZ-4973 (2008) (finding where sbir/sbirstir/SBIR_SBIR_DESCRIPTION.html. state policy makers. Economic research, policy supermajority approval requirements for cer- analyses, and small business outreach help 36. See 13 C.F.R. §121.702(a). tain fundamental corporate actions not identify issues of concern. Regional Advocates required for decisions regarding daily opera- 37. See SBIR/STTR Reauthorization Act of 2009, and an office in Washington, DC, support the tions of the business did not constitute nega- H.R. 2965, 111th Cong. (as passed by the Chief Counsel’s efforts.” tive control). House on July 8, 2009, and Senate on July 13, 42. SBA Office of Advocacy: “Impact of Tight 2009). 25. See Size Appeal of: Dell-Star Corp., SBA No. Money and/or Recessions on Small Business” -2663 (1987) (finding that although the affiliate 38. Ibid. The bill also states that a “VCOC con - (June 2003), available at www.sba.gov/advo/ VCC had a minority interest of stock, through trolled by a business with more than 500 research/rs230tot.pdf (“Smaller businesses agreement, it had a majority position on the employees has an ownership interest in a small rely more on lending as a source of credit board). business owned in majority by VCOCs, that than do larger firms. As a consequence, smaller small business is eligible to receive an SBIR or businesses may be more adversely affected 26. See, e.g., Size Appeal of: TSP TWO, Inc., SBA No. STTR award only if: 1) not more than two of when tighter monetary policies or adverse con - 3009 (November 29, 1988) (explaining that the such VCOCs have an ownership interest in the ditions in banking reduce the overall supply of definition of “affiliates” in 13 C.F.R. §121.103 small business; and 2) such VCOCs do not col - bank .”). See also Keric B. Chin and Rich - (previously §121.3) contains no exemption for lectively own more than 20 percent of the ard J. Vacura, “Small Business: SBA Rules to venture capital firms); Size Appeal of Union small business.” Continue to Impact Ability of Small Businesses Metal Corporation, SBA No.-2578 (December 22, to Raise Capital,” BNA’s Federal Contracts 1986) (“We have consistently held that invest- 39. See www.nextgov.com/nextgov/ Report Analysis & Perspective (August 25, 2009), ment companies, or holding companies, and ng_20090526_1094.php; and www.baracko- available at Westlaw, 92 FCR 152. the firms they own are subject to the affiliation bama.com/pdf/SmallBusinessFINAL.pdf. 43. SBA: “Overview & History,” available at www. rules because of the power of one to control 40. Karen Gordon Mills, the current administrator the other or others”). smallbusinessa.gov/aboutsmallbusinessa/his- of SBA, is a former private equity investor and tory/index.html. 27. See Size Appeal of: International Laser Machines adviser and the former founding partner and Corp., SBA No.-2541 (November 7, 1986) managing director of Solera Capital, a New 44. See Chin & Vacura, op. cit., at 1. (rejecting the argument that because a venture York–based venture capital firm (www.wash- 45. Ibid. capital sponsor was merely a passive investor, ingtonpost.com/wp-dyn/content/arti- 46. Ibid. it did not have the power to control the con- cle/2008/12/19/AR2008121902112.html). tractor and finding that investment/holding Winslow Sargeant, the former managing direc- 47. See, e.g., Chapman, “Obama Appoints Venture companies are not “within the terms of the tor at the venture firm Venture Investors LLC, Capital Executive to Head Small Business specific exemptions in the size regulations... was appointed by the president as SBA chief Administration,” HuffingtonPost.com (Decem- subject to affiliation rules”). counsel for advocacy. ber 23, 2008) (arguing that by allowing VCC- backed small businesses to participate in the 28. Ibid. 41. See http://blogs.wsj.com/venturecapi- tal/2009/05/22/obamas-sba-nomination- small business contracting regime, “billions of 29. SBA No. 3009 (November 29, 1988). nods-in-favor-of-vc-industry (citing a 2006 dollars [will be diverted] away from the middle 30. Ibid. interview with the Wisconsin Technology Net- class economy and into the hands of wealthy work in which Sargeant stated: “The majority investors.”). 31. SBA also noted that the definition of affiliates of SBIR/STTR grants will still go to small busi- found in the size regulations does not provide 48. 13 C.F.R. 121.406(a)(1). ness...[and the] rule limiting the size of a com- an exemption for venture capital firms and 49. 13 C.F.R. 121.406(b)(3)(ii). pany to 500 employees or fewer would still be explained that there was no evidence to sug- in effect. Early-stage research would not 50. 13 C.F.R. 121.1204(a)(4)(i). gest that the investment company was exempt change significantly. I could see more partner - under the Small Business Investment Act of 51. 13 C.F.R. 121.1204(a)(7). ships with corporations.”). 1958 or the Investment Company Act of 1940. U.S. Small Business Administration; Office of 52. Available at http://yourbiz.msnbc.msn.com/ (Ibid.) Advocacy, About Advocacy, http://www.sba. archive/2008/04/25/941211.aspx. gov/advo/about.html. “The Chief Counsel

40 Contract Management | February 2011