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A small line item in the $778 fiscal 2022 Defense Department budget is the subject of intense scrutiny Washington and Silicon Valley.
Small business contracting set-aside programs, known as the Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR), provide roughly $3.5 billion annually in government money for startups and other small companies. Around $1.3 billion of that comes from the DOD. Both programs are up for reauthorization this year and will expire Sept. 30 if Congress doesn’t act.
Critics, including Sens. Rand Paul (R-Ky.) and Joni Ernst (R-Iowa), are pushing for changes to address national security concerns and overall abuse of the program by a few dozen companies. Champions of the program, including House Small Business Committee Chair Nydia Velazquez (D-N.Y.), cite the need for protecting small business, especially during troubling economic times.
Watching intently are defense investors and emerging technology companies. The technology sector is eager to work with the DOD. But they, along with the defense investor community, are leery of the small business set-aside.
“There are so many incredible founders, teams, and innovations being developed,” said Bilal Zuberi, a prominent defense investor from Lux Capital. “Hundreds of millions are being wasted on the same handful of firms that generate limited technology and economic benefit.”
What does the data say?
After 40 years, the small business set-aside programs can point to a number of startups that received funding on their way to billions and success. Examples include: Qualcomm Inc., which received $1.5 million; 23andMe Inc., which received $4 million, and Anduril Industries Inc., which received $12 million.
A deeper dive shows that a small group of firms—dubbed “mills” because they primarily produce contract proposals—are consuming 30% to 40% of the total dollars awarded each year and returning very little to taxpayers or national security.
The top 20 of these “mills” have received $3.4 billion from the DOD and an additional $1.7 billion from other agencies in the set-aside program. Yet in most cases, few tangible products to show for the investment.
For example, Physical Optics Corp. received $577 million in set-aside funding and has generated 22 patents of interest by the government. The company recently sold to an acquiring firm for $310 million. It’s consistently touted as a success story of the set-aside program. But are 22 patents (at about $26 million apiece) and a sale price of about two-thirds its total government awards a good investment? Unlikely.
In another example, Luna Innovations Inc. received $198 million from 2009 to 2021, $165 million from the DOD. That figure represents 30% of the company’s revenue over that time, but less than 1% of Luna’s total revenue during the same time is associated with capabilities that strengthened national security.
Luna recently announced that it sold Luna Labs—the division that was awarded so many SBIRs—for $21 million. The company also said SBIRs will soon represent less than 5% of its total revenue. This seems like a poor investment for DOD given that Luna (and presumably Luna Labs) received $21 million in 2021 and $55 million over the last three years.
Why should the taxpayers keep investing so much into so few for so little?
In short, we should not. Advocates for the current programs say that they are protecting small businesses and the industrial base. No, they are protecting a few dozen businesses that are dependent on non-dilutive funding year after year. As is, the programs stifle new entrants and companies with diverse founders and backgrounds.
Senator Paul is viewed as the wild card that is threatening to shut down the set-aside programs. His actual proposed changes are fairly benign and would both limit abuse from mills and combat foreign influence. They include limiting companies from solely profiting on government contracts, open calls for new ideas and technologies, and improved due diligence processes.
There are a few other simple fixes that could put the programs back in the hands of hundreds of emerging companies that are focused on DOD innovation and commercialization.
- Cap annual awards. Very few companies can support multiple grants effectively and build innovative products and businesses. A cap on how much money they receive could free up as much as $200 million in annual awards and would only impact a few companies—who solely focus on penning contract bids—negatively.
- Cap total awards. In the same vein, capping total awards would force companies to prepare for a future of not being dependent on small business set-asides. If they create enough innovation and commercial success, they would be able to find other avenues for additional financing.
- Address national security concerns. Companies could set themselves up to pre-qualify for SBIR awards ahead of applications, and third-party services could be used to quickly vet thousands of new and competing companies.
This big little fight will either be resolved soon or the programs will lapse. The general consensus among observers is that small business set-asides have great potential, but limiting or excluding the mills seems off the table.
Will Congress make a bold move in an election year to seed long-term innovation? The warfighter, taxpayers, emerging technology companies, and investors are watching.
Ben Van Roo is the CEO and co-founder of Yurts Technologies Inc, an application development platform for large AI models. Ben also sits on the Advisory Council for the Global SOF Foundation, a non-profit organization for the global special operations community. Prior to Yurts, Ben built the National Security team at Primer Technologies Inc. and was a national security policy researcher at The RAND Corporation. Ben has a PhD in Operations Research from the University of Wisconsin-Madison.
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