May 23, 1997

CREATIVE FINANCING FOR SMALL BUSINESS, PT. 2

Edited by Dennis Berman

This is part two of Enterprise Online's special report on creative financing. (See also May 22, 1997, "Creative Financing for Small Business, Pt. 1") The following is an edited transcript of a May 13 meeting sponsored by the Manhattan chapter of the Massachussetts Institute of Technology Enterprise Forum, a nonprofit alumni group. It features the briefings and Q & A's of two finance chiefs, Ritchie Coryell and Anthony Lando.

Ritchie Coryell, Director, Small Business Innovation Research Program (SBIR) of the National Science Foundation (NSF)

I'd like to cover a brief outline of the SBIR program.

It is a program that was initiated 20 years ago at the National Science Foundation. We had a very small program that was never really more than $4 million a year at NSF, until 1982, when the U.S. Congress picked up on these program concepts and extended it to all the major research and development agencies of the federal government...They had in mind not a welfare program for small business. What they saw in the small high-tech firm was a dynamo of creativity and new economic development and there's much evidence to suggest that this is certainly true.

They also wanted to open the door to small high-tech firms for a genuine participation in federal R&D. At the time of enactment in 1982, small firms accounted for only 3.5% of total federal R&D -- with R&D now amounting to something like $70 billion per year, which itself is more than 40% of total national R&D expenditures. SBIR was seen as their access-key to participating in that large federal enterprise.

This fiscal year, 1997, the total [research and development money] available is $1.1 billion among [government] agencies, so there's a lot out there. Before you get the idea that it's free money, listen further.

The eligibility requirements are rather simple for small high-tech firms to compete for these funds; Your company must be 500 employees or less -- that's the definition of small in the U.S; Not dominant in its field -- that's not a difficult thing to satisfy; It must be organized for profit, that might make you chuckle, however you'd be surprised at the number of non-profits that try to get in on the act. This program is set up for small high-tech firms organized for profit. That doesn't mean you make a profit, but you understand the term. Also, foreign companies may not compete but foreign-owned companies operating in the U.S may apply and compete for funds.

The SBIR Phased Project Structure is as follows:

Phase one is a six-month feasibility research stage. Under the act, an agency may give up to $100,000 of support for that. Each of the agencies that conducts an SBIR program, conducts the program to advance its own R&D mission and needs. Its requirements are often tailored to that.

Phase two is the principal research stage, where the concept is advanced to the point of a laboratory prototype or a first reduction to practice. An agency may go up to $750,000 for a two-year effort. In NSF we are presently advertising in our current solicitation two projects at $400,000. You might guess that the larger agencies, more bountifully equipped with budgets like the Defense Department and NASA, will go up to the big numbers. The smaller agencies hover around the smaller numbers.

Phase three is really the pay-off on this program. Phase three is not funded by federal funds unless the federal government is the principal consumer of the technology that is being developed. And that will, of course, happen most often in the Department of Defense, where military technologies do not normally have at least a direct application in the private sector. So, for all intents and purposes, in the other agencies, notably in NSF, my agency, you want to be thinking in terms of phase three. You will go to private-funding sources and look for funding to complete commercial development and to bring your high-tech product into the marketplace.

Each of the agencies has a distinctly different flavor and mode of operation. That's because our missions are very different. NSF does not have the mission of space exploration. Our business is not health and medicine as in the case of National Institutes of Health. Our business is not military preparedness.

The business of NSF is to insure the health of science and engineering in the U.S. The direct consequence of that mission is that we cover a very wide waterfront of the science and engineering disciplines, and indeed, our solicitation is built around 26 topics, most of which key to some area or discipline of science and engineering like physics, chemistry, or biology.

I mentioned that there is a junction of separate funding in the early stages by government in phases one and two, but a private funding in phase three. So, you're thinking right away, what you would like to do is get the government's money in phases one and two, and at the end of that come up with a new idea, go back to the trough and get another phase-one project and continue in that cycle. This is what we call the "beltway bandit syndrome." We're very familiar with that down in Washington. SBIR is not designed for beltway bandits, at least not at the NSF. The key factor about that and it's in the act, is that we give a coupling between the government-funded research and the privately supported commercial development by means of an event called the Follow-On Funding Commitment or (FFC).

Now the Follow-On Funding Commitment is an agreement that the small firm enters into with a third party private source, wherein that third party commits to pick up the tab in phase three if everything goes smoothly in phase two. It's a conditional agreement. Before we put up the phase two money in SBIR, we want to know where that phase three money will come from, so that when Uncle Sam's money is completely spent, there is somebody else there looking over the shoulder of the small firm -- somebody with a vital interest in the full completion of that research. Which means, you've got a product on the market. How do you get these funds? Each agency will issue a solicitation for proposals. They call for proposals at least once a year.

You then give us a proposal strictly limited to 25 pages or less. Twenty-six pages and you will not be considered. That's government. It must arrive on time. If it's a day late, then it will not be considered, so you want to be real careful about that. You submit a proposal, the agency evaluates it in six month's time. The winners and losers are notified by mail at the end of that time. I say it a little bit tongue-in-cheek, but if you get an award sometimes when you get a [rejection], you will never be the same. What do I mean by that? SBIR is interest-free financing for your company, yet it is not free, it will cost you. You must abide by the Federal Acquisition Regulations, which means not all of your costs are recoverable under government grant or contract. You will possibly be audited by federal auditors and that's not fun. You will have reporting requirements. And you will have the emotional rollercoaster of losing and waiting to find answers to your cherished ideas that you're so proud of -- on which you built your dreams for your future.

Nevertheless, I do recommend the program for your consideration if you have not gotten into it before. There is much support in the New York state government and in Connecticut and New Jersey, neighboring states that I know about. There are ways that you can find some help to get up on the curb quickly and to compete effectively with these funds.

Anthony V. Lando, Senior Vice President & General Manager, BTG USA Inc., (British Technology Group)

I represent BTG which, is listed as the British Technology Group. We spent about $1 million with some really creative advertising people and they came with a new name for us and that was BTG.

BTG basically is responsible for acquisition of technology through a variety of sources -- small companies, universities, single inventors, large companies, whatever. We create an intellectual property package around the technology, usually in the forum of a patent, trade secret, and know-how. We create an asset and then we move it through a value-added chain. That's done by doing things like licensing the technology, or wrapping a company around that particular technology or technology management for a company that's going through the process. Potentially, we work by putting in some seed capital, usually somewhere between $50,000 to $500,000. We are no longer venture capitalists in the UK so we're a little bit more restricted these days.

BTG has been around for almost 50 years now. We went public in 1995 and our market cap is about $1 billion dollars. This is on the back of technologies some of you may be very familiar with; yet you never knew BTG existed -- things like Magnetic Resonance Imaging, Cephalosporin (antibiotics), Pyrethrin (insecticides) and the Hover Craft. If you used any of those products or have been involved in any of those products through some channel, you have paid a royalty to BTG. In some cases we have had positions within the company and in some cases it was a straight license.

How does licensing play into this? Well, most small companies and most entrepreneurs have a goal of trying to reach the public market over some period of time. To do this, there are a number of hurdles and steps you have to climb in order to get there...One thing that's usually important when you go to a venture capital group or you look for financing is that you have a proprietary position. Proprietary positions in some of the high-tech markets today can be very difficult to obtain. Yes, you can file for a U.S. patent. You can declare that you have trade secrets. You can use outside lawyers to help create that intellectual property for you, but that's sort of the easy step. You've got 12 months from filing the patent application until deciding what you're going to do in the rest of the world. At that step, it can get a little bit expensive because you need to look at an extensive filing program. You need to look at things like how you're going to deal with the Pacific Rim, Europe and some of the emerging markets. Probably, more importantly, this requires a specialist's knowledge that usually small start-ups and entrepreneurs don't have access to without paying some fairly hefty bills.

What BTG does is try to come into that stage and work with the intellectual property that's either been developed or being developed during this process. What most people don't look at is an avenue of licensing. It's very straightforward, very simple. Licensing can be done in a number of ways to create income in the early stages of an entrepreneurial venture where you don't necessarily have to have product on the market. You don't necessarily have to have revenue from existing product coming into your company, either.

To protect your position, let's say in the U.S. or in a particular field, you can do licensing and restrict it in geographic locations, restrict it to various field and market segments, or give people limited exclusivity or non-exclusivity in a variety of mechanisms. Basically, you can shape the deal in a way you think is appropriate to get an initial down-payment or infusion of cash, which would go to help fund some of the ongoing activities of that entrepreneurial startup.

The typical licensing approach that most inventors or entrepreneurs take is what they know best. And what they know best is usually a technical channel. So, they take technology, take the idea and if they decide they will do something like licensing, they will go out and look at companies and try and find their way in through, most typically, the engineering or technical side of the house. Eighty percent of the time it results in very long decision-making times between exposure of the company's technology and the final decision. It's fraught with a lot of frustrations and a lot or requirements from the entrepreneur trying to clear hurdles, overcome not-invented-here syndromes, and find the internal champion and move it through the channels. At the end of the day, licensing is a business decision and this doesn't work.

The BTG model and also a model that entrepreneurs could use is to focus on what the real unique selling features of the technology are. Decide what the benefits of the technology are in the marketplace, target specific companies and get into those companies through the business channel. Product managers have amazing power when they're faced with a competitive environment and your technology offers them an advantage that is quicker and cleaner to market, especially if you add a know-how package which reduces risk on their engineering or development teams.

Sometimes licensing is a daunting task. I know because in our operation it sometimes is. We have been doing it for 50 years. For a new entrepreneur looking at this channel, there are a lot of hurdles you have to go through, but you'll find there are a number of opportunities where you can learn licensing or use people to help you license. These are the kind of things that need to get done during the licensing commercialization process.

The most important thing to remember is that licensing is a contact sport. You don't do it by sitting in a room. You've got to get out in front of people and let them know about your technology and how it will benefit them, and try to sell them the concept of what your vision is. It's also important that you remember at all times that licensing is a business decision, it's not a technical decision.

When a deal is over, it's not done, the party's not finished. There are a lot of other things that you can look to which can generate increased revenue flow into the startup or into the entrepreneurial venture. These are the kind of services that BTG provides to its sources of technology when we do license deals.

One of the things that's very interesting is monitoring licensing, compliance databases, things like that, and doing audits. Over the last five years, we've generated over $40 million in audit income by a special team of auditors we have who go out to our licensees because the license is misinterpreted or had provisions on the stock, etc. That money was particularly generated where patent life had ceased.

If you write an appropriate kind of agreement and if you're clever about how you construct the agreement, what you can do is not only gain royalty income from a steady stream during the life of the agreement, but when that patent is over you can reach out and also look at continued revenue through a variety of mechanisms. There is a number of ways of partnering with BTG, but also partnering with small groups that do licensing and provide licensing services. There's obviously assignment and exclusive licensing. There's a synergistic relationship that's usually used with universities.

Also, revenue share only when there is a fully success-driven relationship, which is what I suggest if any of you use a third party or broker, including BTG. You force the relationship where it's success-driven and that doesn't burden you with any up-front costs or any significant cash involvement, if any at all.

Questions for Ritchie Coryell

Q. In the Phase three and commercialization plan, what are the important points for the government?

A. I can answer that for NSF. We look for a reasonably firm commitment. We're looking for solid intent by the outside third party investor in that company, typically $200,000, but it's a competitive matter. The larger the commitment, the more solid the commitment, it lends strength to the proposal and makes it more likely to receive the reward. I've seen commitments where they put so many caveats on it you can tell there wasn't the solid intent.

One of the things that this commitment does for government is to tell us that there is somebody out there really voting with his money about the worth, the commercial worth of that technology. I think the genius of this program design, in effect, is that government is looking to the private sector, at least the sampled one, to tell us that this is something worth putting money into rather than a straight-out decision by government that these are winners and these are losers.

Q. Is there a clearing house that you call that describes the technology that your offering, or can you get loyal information? Can I call you and find out in four months that I'm in the wrong slot?

A. Well, you may certainly call me and I'll try to direct you to another agency if that's useful to you. The U.S. Small Business Administration has a "watchdog" role under the law, over the agencies. SBA is not an R&D agency so it's not making grants or contracts for research. On the other hand, it does have a Web page that provides you with the schedule and the dates for all of the agencies with their solicitations, their due dates, their award dates, that sort of things. The SBA Web site is at www.sba.gov.

What they will do is provide you with titles of topics -- that is not the full description you would get with a solicitation document -- but you can get a good one-liner to get an idea of the topics that the agency is interested in that year.

Questions for Anthony Lando

Q. What stage of product development do you think potential licensers want to see before you can approach them. Where does it have to be a completed prototype? Where do you find it?

A. It depends on the licensing arrangement. I don't think you have to be at that stage at all. Typically, the value of what you're going to receive in terms of a downpayment or license income is going to depend upon, particularly the up-fronts, the amount of know-how you transfer with the license. The more know-how, the higher the up-fronts. As far as long term income, you're really putting the burden of product development in a particular market segment or geographic area on the licensee. You can create milestones so that he has to perform and he doesn't sit on your technology. Basically that's going to provide a revenue stream for you.

Q. Can you just show them a patent or do they want to see a prototype?

A. If you've got a good patent, usually, again, your up-fronts will be less. If you've got a good strong patent, a prototype developed and you've got a nice know-how package and you're willing to provide some access to a particular market, maybe exclusively for a period of time, you can see quite sizable up-fronts.

Q. How much experience does your company have with the software industry and how do you also interact with the telecommunications industry?

A. In software, quite a bit. As you know, the patent law is a little bit different when it comes to software. We try to look at basic algorithms. We try to look at best mode implementations. We try to look at things like that. One of the things that BTG likes to do is we have our own patent attorneys or we use external patent attorneys in certain key areas. But we instruct those patent attorneys and we're always looking to create offensive strategy on the patents.

We want people to see value in those technologies, particularly in software. We want potential licensees to see that we have broad coverage and substantial issues they need to address if they want to bring a particular piece of technology to market. So we do have a lot of experience in software.

In the telecommunications area, we have been active quite awhile. We have rights to the fiber optics amplifier that's being used for underseas communication, treacle applications cable. We do quite a bit in audio and video compression, video browsing technologies, all have application to both telecommunications and more importantly communications in general: integrated media and communications, the convergence of conventional telephony and image distribution display.

Q. What does your initial investment actually buy you?

A. We don't buy technology. What we'll do, if there's a particular company or small entrepreneur who has a piece of technology that's either patented or able to be patented, is we enter into a commercialization agreement. As part of that commercialization agreement they may need some cash to do something in a particular market segment, but we're not going to have rights to license. There may be a marketing launch in the U.S. that's required and we would have rights outside the U.S. to commercialize the technology. It really depends on what the issue is. Sometimes if the technology is really good, we'll make a more substantial investment and take an equity position. We'll wrap a company around the technology if that's appropriate. Sometimes we take the technology, wrap the company around it and apply for an SBIR. And we are the phrase three partner that Ritchie Coryell is talking about. That, in fact, is a very common application when you have certain kinds of technologies.