DOD worried struggling tech startups will miss out on U.S. aid and fall prey to foreign investment

By Justin Doubleday  / April 2, 2020

The Defense Department's top official in Silicon Valley wants to ensure struggling technology startups will qualify for emergency small business loans, as he worries companies could instead turn to Chinese and Russian investors.

In an April 1 letter to officials at the Small Business Administration marked "for official use only," Defense Innovation Unit Director Michael Brown writes the coronavirus has put non-traditional defense suppliers "under intense pressure."

"Many of these startups are either furloughing workers, laying off workers, or facing a potential shutdown," Brown writes.

DIU scouts and prototypes commercial technologies with national security applications. It has offices in Silicon Valley, Austin, TX, Boston, MA and at the Pentagon in Washington.

The group's technology portfolios include space, artificial intelligence, cyber, autonomy and human systems. DIU is seeing "the most acute financial pressure" in the commercial space business for now, "but we expect that financial pressures will soon develop in each of these areas," Brown writes.

Brown asks SBA to clarify whether startup businesses backed by venture capital will qualify for loans under the CARES Act signed by President Trump last week. He warns many critical technology companies could lay off more employees or turn to foreign investment instead.

"We feel strongly that without U.S. government aid, Chinese and Russian investors can more easily gain ownership stakes in these companies," Brown writes. "These tactics used by our adversaries will accelerate the transfer of critical U.S. technology with national security applications and we must do whatever we can to prevent it. Failure to stem the tide of layoffs or stop U.S. adversaries from accessing leading-edge technology at startups could cost us years of progress and, ultimately, make the country weaker."

The CARES Act includes $350 billion for small business loans under a "Paycheck Protection Program." Businesses can start accessing the loans on Friday.

But SBA's rules on equity investors could push many venture-backed startups above the 500-employee ceiling for qualifying as a small business, according to a March 29 letter sent to Treasury Secretary Steve Mnuchin and SBA Administrator Jovita Carranza by industry-backed groups TechNet and the National Venture Capital Association.

"Depending on how the SBA assesses questions of 'control' under current 'Affiliation Rules,' many of these companies could be required to aggregate the employees of unrelated companies in which their investors are affiliated and count them in their employee count, pushing many above the employee size threshold," the letter states.

Alex Burgos, TechNet's senior vice president of federal policy, told Inside Defense in an email that the SBA program is "the single best critical lifeline available" for startup businesses trying to prevent more layoffs.

"Normally, start-ups would have more time to explore all funding options available to them, including existing equity investors as well as new ones in the U.S. and abroad," Burgos wrote. "The problem here is that layoffs are already happening and will only grow unless there is immediate relief, which the SBA's paycheck protection program could offer right away if these rules weren't standing in the way."

SBA did not immediately respond to questions about the affiliation rules.

Brown's letter this week comes after Pentagon acquisition chief Ellen Lord last week warned the defense industrial base "is vulnerable to adversarial capital, so we need to ensure companies can stay in business without losing their technology."

During a March 25 press conference with reporters at the Pentagon, Lord said DOD is hosting virtual events through its "Trusted Capital Marketplace," an initiative launched last year to connect U.S. technology start-ups with "trusted" venture capital.

She said the coronavirus outbreak and subsequent economic downturn could present an opening for foreign investment from potential U.S. adversaries.

"I think it presents a greater attack surface, if you will, as there is uncertainty especially with small businesses as to whether their contracts will continue," Lord said. "So we want to basically mitigate that uncertainty. That's why we are being forward-leaning and over-communicating, probably, to say we are open, we want them to be open."

For its part, DIU "continues to operate 'business as usual' with some minor exceptions," according to a March 31 message posted to its website. The organization is "maximizing the use of teleconferencing, voice, and email communications to support ongoing projects and new business opportunities," but continues to pursue prototyping projects.

"DIU continues to actively open new solicitations and execute new agreements in support of our mission to accelerate commercial technology for national security," the message states. "At this time, our ability to process milestone payments or other required contracting actions is unaffected."