Venture Backing of Defense Firms Foiled by Small Business Rules

The Pentagon’s effort to draw more commercial investment to technology with military uses is thwarted by regulations designed to ensure the viability of small business vendors in the federal contracting base.

This tension is increasingly apparent as more venture capital firms direct cash at government contractors They then come up against Small Business Administration rules at odds with practices standard in startup investment.

Running afoul of regulations around small business certifications can mean losing contract awards or set-aside status, or—in extreme cases—False Claims Act investigations.

Investors say these SBA rules slow the flow of financial support for startups at a time the Defense Department is looking to boost the number of technology companies in its supply chain as one way to counter advances made by China.

For startups working on dual-use technology—applicable in commercial and defense contexts—the small business regulatory environment is an obstacle to starting government work. It can also turn venture capital firms off from funding those startups.

“If you want to see these companies that are supporting the government have the right backing and be capable enough to actually endure the bumps and bruises of working with the government, which I believe they do, you’re going to have to be a bit more flexible on things like negative control and other parameters,” Dave Harden, founder of The Outpost and managing partner at Outpost Ventures, said in an interview.

Different Standards

“Negative control” rules state that a small startup controlled by a much bigger firm or fund isn’t eligible for small business set-aside opportunities for contracts. That has the potential to stop a company from succeeding in, or even entering, the defense industrial arena dominated by established giants.

The kinds of activity SBA considers “control” include VC-industry standard clauses that give investors a say in big decisions made by the portfolio company, such as to block major changes to the executive team or dividend payments.

These sorts of controls are common with VC investments in the commercial market. Restrictions in the federal market can come as a surprise for contracting newcomers. They may find themselves at the wrong end of a competitor’s protest.

“It happens when you actually bid on something, you’ve actually won something, and then someone says ‘Houston, we have a problem,’” Damien Specht, partner in Morrison Foerster’s government contracting and public procurement practice, said in an interview.

An SBA spokesperson told Bloomberg Government the agency doesn’t keep data on how many firms have been removed from its rolls for negative control issues.

Reaction Cycle

The SBA does allow certain controls around so-called “extraordinary actions,” such as giving investors controls over a company declaring bankruptcy or selling most or all of their assets. Some programs, like the Small Business Innovation Research program, include waivers or other exceptions to ease standards.

Exceptions to SBA regulations for tech startups and smaller innovators are often buried in less familiar programs or procurement mechanisms.

Most changes to how negative control rules are understood and enforced come through court decisions on the existing regulations.

The exceptions and fixes can come with their own perverse incentives. Meg Vorland, managing partner at Dcode Capital and cofounder of advisory firm Dcode, said many of these rules just end up encouraging companies to spend time and money gaming the system rather than turning resources to making better products and services.

“Everything has a reaction, and then everyone learns the new game and then there’s a whole cottage industry,” she said in an interview.

Those workarounds also don’t get the best technology to the Pentagon.

“The government has to realize that it has to be a friendlier place to do business if you truly want public-private partnerships, if you don’t want the DOD or the government to be the only one supporting an ecosystem,” Harden said. “You have to create the right incentives for private capital to come in, and the only way to do that is create some flexibility.”

Pitfalls

Risks vary widely for self certifying as a small business despite a potential negative control issue. In some cases, it could be a matter of changing some paperwork with investors. At the other end of the spectrum, however, a company could be debarred from government work or even face criminal investigations if the government believes fraud was involved.

SBA Director of Policy Planning and Liaison Sam Le told Bloomberg Government that most enforcement happens after companies that lose a contract opportunity file protests when they think the awardee that beat them may have negative control issues.

It would likely also come up in due diligence reviews when mergers and acquisition opportunities roll around.

“When you go to sell the business, someone like me is going to come along and look at your negative controls and say ‘You shouldn’t have gotten any of these contracts.’” Specht said.

Even in cases where a quick change to paperwork to remove problematic controls would make a company compliant, there’s no guarantee a company’s partner or investors would be on board.

“It’s certainly not a fait accompli that your investors are just going to waive these rights” to what SBA would call negative control, Specht said. “It’s inconsistent with the way the commercial market does it.”

To contact the reporter on this story: Caleb Harshberger at charshberger@bloombergindustry.com

To contact the editors responsible for this story: Amanda H. Allen at aallen@bloombergindustry.com; Fawn Johnson at fjohnson@bloombergindustry.com