What VCs Need To Know About SBIR Acquisitions

By David Timm

Startups often catch the eye of venture capital investors after they land Small Business Innovation Research funding from America’s Seed Fund. But before jumping into a deal, both founders and investors need to understand how SBIR rules work — especially when it comes to ownership, affiliation and acquisitions.

If you’re a venture investor looking to invest in an SBIR-backed startup, here’s what you need to know about eligibility rules, affiliation concerns and how acquisitions might affect those lucrative government grants.

SBIR eligibility and the affiliation rule

SBIR awards are reserved for businesses that meet these basic criteria:

• At least 51% owned by U.S. citizens or permanent residents; and
• No more than 500 employees, including affiliates.

Here’s where things get tricky: The U.S. Small Business Administration has strict rules about “affiliation.” If two companies are closely tied — say, they share management, employees or even the same address — the SBA might consider them a single entity for size determination.

This can become a major issue when VC firms invest in SBIR-funded startups. If a VC firm controls multiple portfolio companies, the SBA may decide those companies should be counted together. That means a startup with 200 employees and another with 300 employees could suddenly be considered a 500-person company — and risk losing SBIR eligibility.

So what does “control” actually mean? The SBA looks at ownership stakes, board influence and business dependencies. If a VC firm exerts too much control over an SBIR awardee, that startup might no longer qualify as a small business.

What this means for VC-owned companies

Venture Capital Operating Companies, or VCOCs, can avoid affiliation issues if they only hold a minority stake and don’t exert controlling influence over the SBIR recipient.

Unlike conventional SBIR startups, VCOC-backed companies can have parent firms with more than 500 employees. But there’s a catch:

• No single VC, hedge fund or private equity firm can own a majority of the startup; and
• Foreign ownership is allowed, but only if those entities have a U.S. presence and follow U.S. laws for incorporation.

Another key limitation? Not all federal agencies allow VCOC-backed firms to receive SBIR awards. In 2022, the Government Accountability Office found that only two agencies — the Department of Defense and the Department of Health & Human Services — regularly awarded SBIR grants to VC-backed companies.

For founders and VCs, this means a strategic tradeoff: The flexibility of looser VCOC standards comes at the cost of a smaller pool of potential government contracts.

How acquisitions affect SBIR status

Acquisitions and mergers often shake up ownership and headcount, potentially triggering affiliation issues or pushing a company past the 500-employee cap.

The good news? If a company already has an active SBIR award, it remains eligible for that specific contract, even if it grows beyond small business status later on. Agencies can also renew or extend an award without revoking small business status.

The bad news? Future SBIR funding could be at risk. If an acquisition shifts ownership in a way that violates SBIR rules, that startup may no longer qualify for new awards.

Plan ahead to avoid surprises

Both founders and investors need to think ahead before making acquisition moves that could jeopardize SBIR funding. That means you should:

• Conduct a deep dive into how any ownership change might impact SBIR eligibility;
• Develop a five-year roadmap that considers growth, acquisitions and changes in control; and
• Consult with SBIR legal and compliance experts to stay ahead of potential issues.

At the end of the day, venture investors and SBIR startups can absolutely work together — but it requires careful planning. Understanding the rules early on can help avoid unpleasant surprises that could derail government-backed funding opportunities.

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 David Timm is federal government contracts and procurement attorney at Fox Rothschild in Washington, D.C.. Timm’s practice focuses on complex disputes, claims and bid protests over federal, state and local government contracts. He frequently helps companies navigate the Small Business Administration’s rules, including Small Business Innovation Research. He can be reached at [email protected].

Illustration: Dom Guzman