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Entrepreneurship MGT602

Lesson 35

SOURCES OF CAPITAL

LEARNING OBJECTIVES

1. To identify the types of financing available.

2. To understand the aspects of research and development limited partnerships.

3. To discuss government grants, particularly small business innovation research grants

RESEARCH AND DEVELOPMENT LIMITED PARTNERSHIPS

This method of financing provides funds from inventors looking for tax shelters. A typical R&D

partnership arrangement is established with a sponsoring company developing the technology with funds

being provided by a limited partnership of individual investors. Research and development limited

partnerships are particularly good when the project involves a high degree of risk or significant expense.

Major Elements

The three components are the contract, the sponsoring company, and the limited partnership. The contract

specifies the agreement between the sponsoring company and the limited partnership. The sponsoring

company does not guarantee results, but performs work on a best-effort basis. The typical contract

specifies that the liability for any loss be borne by the limited partners. There are some tax advantages for

both the partnership and the company.

This tax deduction is based on two authorizations:

1. Section 174 of the Internal Revenue Code.

2. The Snow vs. Commissioner case of 1974.

Limited partners may deduct their investments in the R& D contract under Section 174 in the year their

investments are made, significantly increasing the rate of return of the investment. The second component

is the limited partners. The limited partners have limited liability but are not a taxable entity. Any tax

benefits of the losses are passed directly to the limited partners. When the technology is successfully

developed, the partners share in the profits. The sponsoring company acts as the general partner developing

the technology. The sponsoring company usually has the base technology but needs to secure partners for

commercial success. The company usually retains the rights to use this technology to develop other

products.

Procedure

In the funding stage, a contract is established and the money invested for the proposed R&D effort. In the

development stage, the company performs the actual research, using the funds of the limited partners. If the

technology is successfully developed, the exit stage begins, with both parties reaping the benefits. In the

typical agreement, the sponsoring company and limited partners form a new jointly owned corporation. An

alternative is a royalty partnership in which a royalty based on the sale of the products is paid by the

company to the limited partnership. The company and limited partners may form a joint venture to

manufacture and market the product.

Benefits and Costs

Benefits

R&D limited partnerships provide the needed funds with a minimum of equity dilution while

reducing the risks.

The sponsoring company's financial statements are strengthened.

Costs

There is considerable time and money involved.

Most R&D limited partnerships are unsuccessful.

The restrictions placed on the technology may be substantial.

The exit from the partnership may be too complex.

Examples

Successful R&D limited partnerships include Syntex Corporation, Genetech, and Trilogy Limited.

R&D limited partnerships offer one alternative to funding technological development.

GOVERNMENT GRANTS

The Small Business Innovation Research (SBIR) grant program helps entrepreneurs obtain federal

grant money to develop an innovative idea. The act requires all federal agencies to share a portion of the

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Entrepreneurship MGT602

R&D funds with small businesses. This provides a uniform method of soliciting, evaluating, and selecting

research proposals. Eleven agencies are involved in the program. Small businesses submit proposals directly

to each agency. The agencies evaluate each proposal on a competitive basis and make awards.

The SBIR grant program has three phases.

Phase I awards are up to $50,000 for six months of feasibility-related experimental or theoretical research.

Phase II is the principal R&D effort. Phase II awards are up to $500,000 for 24 months of further

research and development. The money is to be used to develop prototype products.

In Phase III funds from other sources, such as the private sector or regular government contracts, are

needed to commercialize the developed technologies.

Procedure

The agencies publish solicitations describing the areas of research they will fund. The second step is

submission of the proposal by a company or individual. Each agency screens the proposals it receives, and

those passing are evaluated by experts. Awards are granted to those projects that have the best potential for

commercialization. Any patent rights, research data, and software generated are owned by the company,

not the government. The SBIR grant program is one alternative for a technically based entrepreneurial

company that is independently owned and operated and employs 500 or fewer individuals.