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Testimony 99
SPIE Dallas 97


Carl W. Nelson
Ballistic Missile Defense Organization - US Department of Defense - Washington, DC

A Paper presented at the 1995 Winter Annual Meeting American Society of Mechanical Engineers - San Francisco, CA; November 1995


A little public subsidy to small innovative high-tech firms led to competitive free-market products that also serve anti-missile defenses. With a subsidy from the Small Business Innovation Research (SBI) of the Ballistic Missile Defense Organization (BMDO), small US firms raised $200 million from public sale of common stock, doubled in employment, and are attracting a growing pool of private capital to match and expand BMDO's subsidy. With SBIR, BMDO showed that government can seed the high -tech products it needs, including energy conversion (the focus of this symposium), plus put technology into the free market - and in a way that does not do for the market what the market can do for itself.

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Making new technology for new markets requires science,intuition, nerve, and money.
In the US, the government provides much of the science. Free-market governments, though, let the market provide the intuition, nerve, and money. Even so, such a free-market government can in clear conscience invest enough seed money to sprout a government technology to the point where it can compete in the open market.

The US government has about 125 business subsidy programs handing out $85 billion (Moore, 1995). The two major political parties both love subsidies, not surprising in a representative democracy, and disagree only on means and rationale and beneficiaries (as in tax credits versus direct subsidy) as both parties appeal more to economic nationalism than to economic efficiency. The subsidies for technology development rely on a market-failure view that government should spend (invest) in technology to fill the gap left by inadequate, wrong-headed (short term),industrial investment. Perhaps the highest principled market-failure rationale was capturing the social returns from R&D which Mansfield (1991) found 2-3 times the return to the innovator.

One subsidy program is accepted by both sides - Small Business Innovation Research (SBIR). Its political benefits of helping American small business outweigh any lofty principles of governance. One of the twenty autonomous SBIR programs across government, that of the Ballistic Missile Defense Organization (BMDO), declares that, as a bonus to seeding new technology for anti- missile defense (Nelson, 1991), BMDO investment (spending) has now also gained economic success as reported herein. BMDO's results offer a federal model for commercial technology within free-market precepts.

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SBIR funds US small firm R&D in two competitive phases:Phase 1 under $100,000 to study a new concept and Phase 2, normally under $1 million, to prototype it. After SBIR, the government retains only a right to royalty-free use for government purposes; no repayment, no equity taken.Free money.

SBIR also relies on market-failure. In 1982 Congress found that US R&D was ignoring small business's advantages: more innovation per employee (especially in firms under 20 employees), more new jobs created, and more new products. Several studies (Fineman et al, 1976) found that small firms do far better at innovating. Economists saw productivity gains of 80% from small firm R&D and big firm production (Anon, 1976).

So Congress enacted a government-wide SBIR with a double purpose: to get small business innovations into federal R&D and into the marketplace.

From 1983 to 1991 more friendly evidence mounted. Studies (Romeo et al, 1984) found more efficient innovation in small firms. Engaging theories, like Gilder's microcosm, argued that the microchip would favor nimble businesses able to infinitely specialize (Gilder, 1989).Congress's GAO (1992) found, by surveying the beneficiaries of 1457 Phase 2 projects, that firms receiving a total of $1000M of SBIR from 1983 to 1991 then received $1100M in new revenues and investment with claimed prospects for $2000M more. So Congress doubled SBIR to $1000M per year (by 1997) with more commercialization.

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BMDO wants to commercialize new anti-missile technology so that private capital will create products that will then generate earnings for further investment in the technology. Anywhere along that path, BMDO can tap the technology for anti-missile defense from a healthy industry

BMDO funds pre-competitive (high technical risk) anti-missile technology to reduce the risk enough to induce early private investment. BMDO attacks only technical risk,the chance that the idea will not work- it does not attack business risk, the chance that the product will not sell. Nor is BMDO's purpose to lower the cost of capital- instead, BMDO gives creation capital otherwise unavailable at any price. Besides, seekers of subsidy overstate the cost-of-capital barrier (Morone & Paulson, 1991). If ROI can be calculated, the idea belongs in the marketplace.

BMDO gets another bonus when the market develops competing technologies in that BMDO can thereby avoid unwittingly trapping itself in inferior technology by choosing too soon from among immature options, especially to cut total R&D costs (Cowan, 1991). Pre-competitive also precludes its use in the first generation of anti-missile defenses. Seeds make poor bullets.

BMDO gives the firm money and incentive. A typical Phase 2 offers the company $300,000 to reach some technical performance threshold and then a dollar-for-dollar match of private sector investment for another $400,000. If all goes well, BMDO may offer additional funding (maximum so far of $2M) with a higher matching ratio. Since the SBIR law imposes no limit on any project, although Congress favors a broadcast sowing of seed money, BMDO may go beyond $2M if technical risk is still palpable and the private sector matching ratio escalates with the money, rising, say, to 10:1.

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BMDO's SBIR firms gained clear economic success from BMDO's $250M investment in 400 Phase 2s by 200 firms:
bulletResult 1: ten firms raised $140M in Initial Public Offerings (IPO);
bulletResult 2: employment doubled in the average firm;
bulletResult 3: private capital is flowing to a growing number of firms to match BMDO funding.

The ten firms who sold public stock each had enough BMDO SBIR funding - a total of $13M - to noticeably speed their technology's maturation. Six won their first Phase 2 from BMDO. The median IPO firm had eight employees at its first BMDO SBIR. Their total market capitalization has swung between $300M and $800M, normal gyrations for young stocks. One saw its market capitalization quintuple; one was delisted for inadequate capital. Two more firms, with small SBIR contributions, raised another $60M by IPO. The twelve companies together had a mid-1995 market capitalization of $1.3 billion riding the wave of a turbulent 32% increase per year in technology stock values since 1991.

Five more firms say they will go public for about $50M "when market conditions are right".

Although going public wasn't BMDO's goal for any of these firms, it serves BMDO's interests by accrediting the technology and the firm. To go public the firm had to convince underwriters and investors of its profit potential, underwriters and investors who care nothing for technological elegance. Being public also admits market capitalization as an SBIR evaluation measure and imposes a business discipline on the firms. A drive to go public also separates the contract houses who serve existing institutions from entrepreneurs who will build an internationally competitive American market, as "In the fast-paced world of Silicon Valley, the entrepreneur's dream is to found a high-technology company which will grow with sufficient speed and prosperity to present a `winning' image and go public" (Bourgeois & Eisenhardt,1987).

The doubling of employment (from first BMDO SBIR proposal to most recent proposal) is far above the US average of two percent per year and somewhat better than the average American small high-tech firm. In the decade 1976-1986, firms under 20 employees grew 155% and firms under 500 employees by 81% (SBA, 1990). The SBIR firms average only half a decade to double. Of the 69 firms with two or more BMDO Phase 2 SBIR awards, 24 have become gazelles (firms that double in four years) (Anon, 1994). In those gazelles, employment has tripled.

Did SBIR cause the employment or vice-versa? A few firms, with a little SBIR and relatively large employment and growth, grew for reasons beyond SBIR. One even appears in the top 200 federal contractors (but still 95%R&D). These firms already had R&D contracts with DOD agencies who preferred predictable progress to chancy innovation. Even without that sub-group, the employment still doubled but the number of added employees would have been fewer.

Using employment as a measure, though, may well understate the economic impact since
bullet1. the SBIR firm represents only a fraction of the new economic activity, and
bullet2) growth of the inventing firm is often not the economically efficient deployment of the technology.

Indeed, useful truths about industrial organization are shifting (Peters, 1992) and a debate rages over whether "small is beautiful" or merely small (Harrison, 1994). Private capital, a much stronger measure of future economic activity, is pouring into BMDO SBIR projects. By mid-1995 over $30M was committed, spent, or planned for 100 projects entering Phase 2 since 1992. Projects in 1994 and 1995 average about eighty cents of private sector money for every BMDO SBIR dollar. Now only about ten percent of projects get an unmatched subsidy, whereas all got it before 1991. Typical matches are carbon-carbon materials with an aircraft brake company, a cryogenic cooler with a pump company, and a polymer dielectric with a chemical company. The growth of private matching is shown in Figure 1 where the light colored portions atop the Phase 2 amounts show private capital in Phase 2. Occasionally, BMDO waives the matching condition because the firm already serves the market profitably as does a firm that raised $50M in early 1995 whereupon BMDO's only question is how much of the $50M to count as matching SBIR.

Of all projects ended by mid-1995, 55% were technical successes hoping for more government money (which few will find). Quickly, though, their number is fading as Phase 2 proposers scramble to stay competitive by recruiting private-sector partners. In two years the commercializers will own the field whereupon the program evaluation can abandon measures like "percentage successful" and look only to total return. (Percentages, which imply that all successes are equal, are loved by government as a measure of participation, not of investment success.) Then the big returns to the firms going public will dominate any evaluation. The top ten percent of the projects will generate practically all the return as they do in venture capital portfolios.

Unhappily, 15% failed. BMDO expects frequent failure in the most technically innovative ideas where 15% may even show excess conservatism. A program with no failures took no risks, made no revolutions, and disturbed no doctrines. Ten firms disappeared and a few teeter on the verge. BMDO will not save them by sending SBIR money. (Only politicians, not capitalists, want to save dying enterprises.)

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As in any program that passes out large money to small clients, BMDO's SBIR has some spectacular successes. Company A had six employees when it won its first SBIR in 1986 (from BMDO) in magnetic bearings. By mid-1995 it had 120 employees (plus 30 professors consulting), raised $22M in public offerings, won $25M in commercial contracts with a projection of $38M for 1996, made a deal with an auto-maker for a new drive train for a 30% more efficient automobile, and started making a profit. Its mid-1995 market evaluation (the number of outstanding shares times the NASDAQ trading price) of $100M was quadruple its 1992 IPO value and the key to opening big financial doors.

Company B's first three SBIRs (one from BMDO in 1987) led to $25M equity investment including $13M from a 1993 IPO. It formed a joint venture with a large filter maker for a $200M market, bought a company on the other coast, grew from 4 to 140 employees, and crossed into profitability in 1995. In one of its markets it went from a 5% share to a 90% share. Its mid-1995 market valuation of $100M was quintuple its IPO value.

Company C, which had raised 20% of its initial capital in 1988 with two BMDO SBIRs, raised $11M when it was temporarily the sole world-wide supplier of a blue Light-Emitting-Diode. Its market valuation swung from $40M at IPO, up to $100M, down below $40M, and then zoomed up to $200M in mid-1995 as market prospects for the world's best blue LED varied in the intense world-wide competition. It, too, crossed into profit in mid-1995.

Company D, already public when it won its first BMDO SBIR, has seen its market valuation skyrocket a hundredfold to $120M in four years with its stacked electronic chips and a computer giant as a manufacturing partner.The market value will, of course, fluctuate with the vicissitudes of NASDAQ's auction of expectation.

Company E had no income in 1992 after three SBIRs. With BMDO's offer to match private capital for proving its laser radar tracking in corneal eye surgery, it first did a private placement and then an equity deal with a large European firm. Release for European sales is expected in 1996 after clinical trials in Greece and human clinical trials continue in the US. Post-SBIR investment for the trials will be about $15M.

Company F has raised $2 of private funds for every SBIR dollar and has grown from 3 to 125 employees. It makes and profitably ships silicon solar cells worldwide and recently hired the solar division president of a giant European electronics firm.

In an energy conversion success, Company G got $400,000 matching investment from a portable cooler vendor and a large candy company for the development of a compact, compressor-less refrigerator. A large US manufacturer then opened a vending machine factory.

More and more companies can tell such stories. Although BMDO was not the only SBIR source in most of these firms, BMDO prodded them into serious commercialization.

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By contrast, BMDO's SBIR projects in energy conversion, the focus of this symposium, show much less economic success even though many showed technical successes by government R&D standards. In the early days energy innovations won many SBIRs after which the agencies let the projects languish. They then had to face a long rocky road to market impeded by large firm competitors, agency conservatism, and impatient capital.

A few economic successes happened anyway. Company H has sold many heat pipes, with a growing volume for notebook computers, but SBIR still heavily funds its R&D.Company I's refractory coatings on carbon-carbon struggle for pennies from rocket motor vendors but the underlying foam has found infant market success through an international firm as a bone implant. Company J developed a thermoelectric generator for which it intends to raise many millions in private capital for sales in several nations without modern power grids. Most merely advanced knowledge and gave the company a basis to claim future economic success, a common claim by SBIR beneficiaries. BMDO awaits the market's judgment. Nuclear power for space platforms had many Phase 2 SBIRs - cesium reservoirs, heat pipes, radiators, heat pump - with negligible private sector investment. Many battery concepts are still looking for market magic in incremental advances. New higher efficiency, high performance, solar cell concepts for spacecraft all cost far more per unit of terrestrial power than old stand-by silicon of Company F. High-volume, high-margin solar power may emerge in the coming multi-satellite communications revolution. In heat transfer dreams of diamond and carbon-carbon composites as heat conductors for the electronics industry offer too little cost-effectiveness advantage. Firms found that promises which seduce a government fail in the cost-sensitive commercial market. BMDO cut them off when the technology (or the firm) wouldn't or couldn't compete. Such limited economic success, though, doesn't remove energy conversion from BMDO's technology agenda. The role of funding it merely shifts to the other 97.5% of BMDO's R&D where the competition is on technical merit and military utility.

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When the subject is marketing a technology, Armey's axiom (1995) applies: "The market is rational and the government is dumb". Government needs a market signal (market-pull, not technology-push) if it is to judge commercialization potential, and not just declare victory by procuring some of whatever it developed (Cohen,1994). BMDO has seen furious market signaling in the form of a dramatic rise in projects where private funding matches BMDO funding.

Other People's Money says someone will risk hard money on a wager of future profit. Whoever puts in hard dollars will keep the firm pointed toward a marketable product. More important, OPM usually has more money on call which the firm will need since R&D is only 10% of the total cost of getting an innovation to market. The sooner OPM enters, the better the chance that the project will have the continuous flow of capital that success demands. Commercial markets, after all, don't act like DOD where time matters little until the bullets start flying. Who are these Other People? The instinctive answer, venture capitalists, play only a minority role, although they do seek small openings, "our best returns still come from seed investments of just a few hundred thousand dollars" (Marks, 1995). Money comes from modest size companies with established market channels, from Fortune 500 companies (who supplement their internal predilection for incremental process improvements )(Scherer & Ross, 1990), and from "angels" who invest $10,000M annually in 30,000 ventures (Marucca, 1993). Noticeably little comes from large aerospace companies (who probably have a net cash inflow from SBIR as sub-contractors) who themselves depend on government. Would these Other People have invested anyway? And is SBIR therefore wasted? No one knows, and Congress has not asked. BMDO guesstimates that BMDO's SBIR beneficiaries would have raised half the capital anyway. Is there a price for OPM? Of course. Risk capital deserves a share of any rewards. Some firms plead for pure subsidy to avoid paying OPM's price which is usually a share of ownership. For too many firms the plea is little more than a cover story for unmarketable research results. Since BMDO does not compete with the free market, BMDO does not ask the firm's price of capital, only its availability at some market price.

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DOD sees that commercialization can do more than just satisfy another societal goal. The Clinton administration wants to integrate defense and commercial industry because DOD cannot afford an industry of its own (Mitchell et al, 1995). The Congressional advocates of a strong defense, who also advocate a balanced federal budget, will have to induce private investment into Defense. They must honor Wriston's rule: "Capital goes where it is welcome and stays where it is well treated." (Wriston, 1995). Note that commercialization goes beyond spin-off (spillover). It serves government directly whereas spin-off is just a windfall to the private sector (with, some say, too little fruit on the ground (Kash & Rycroft, 1995). BMDO halts its investment if either BMDO or commercialization is failing.

To get more commercialization into SBIR, DOD has a new "fast-track" whereby Phase 2 proposers who offer dollar-for-dollar matching by a third-party get preference plus a $40,000 extension to the Phase 1. The policy will not, as feared by some, favor well-capitalized firms since practically no SBIR firm has enough risk capital to offer such matching. They must all find third parties. As a measure of size irrelevance, the median BMDO firm with matching has only eleven employees.

BMDO expects more lively competition among small high-tech firms to get SBIR subsidy in technology for anti-missile defense and for markets. BMDO wants to create new technology in firms likely to stay in a healthy long-term business. Since BMDO cannot predict which new technologies it will want in the future, and cannot rely on the government's ownership of the technology as assurance that it will still be available, and does not want to keep investing in all the interesting seed technologies, it looks to the private sector to invest.

How far commercialization can reach has never been tested. A mutual dependence is emerging wherein commercial products are accepted for military use and the military spends more of its R&D to develop commercializable products. Since SBIR is only 2% of DOD R&D (to be 2.5% from 1997 on) it would not be excessive if all DOD SBIR were commercial.

Commercialization advocates, though, should not be lulled into thinking that OPM implies any devotion to military purpose. Even though the Dutch East India Company acted like the [English] East India Company to power a trading empire which rewarded the mother-country, the directors "wanted dividends, not wars, and they begrudged every penny spent on troops and annexations" (Churchill, 1965).

At bottom, BMDO has proved that SBIR can deliver an economic benefit on top of anti-missile technology. And it seeks new technology and entrepreneurial partners for more seed investments. From BMDO's perspective, the more economic activity that flows into an anti-missile technology, the better the chance that the technology will be on the table for military adoption whenever it is needed.

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