SBIR Model Molds ?Virtual? Into Reality

What Arkansas appears to lack in venture capital and “angel” investments, one Fayetteville company is making up for by helping fledgling firms find federal grants.

Virtual Incubation LLC, a business incubator for innovative technology startups, is growing a client portfolio that to date could achieve $44.1 million in total Small Business Innovation Research funding if all of its proposals go through.

Calvin Goforth, president of Virtual, said that figure is probably an overstatement of his firm’s success because it represents the high-side of award potential. But it’s also not unrealistic, he said, and the $6.7 million in Phase I applications already made is an underrepresentation of Virtual’s potential. Solid progress on those first-round projects could qualify companies for another $37.4 million in Phase II funds, hence the $44.1 million listed in the portfolio’s pipeline.

Virtual provides client companies with multitiered management, operational, research and fundraising support. It takes an equity stake in the firms it “incubates,” typically becoming equal partners with the chief technology officer (CTO) and derives some fees from the SBIR awards it helps get.

Most of the private investment into Virtual itself is “sweat equity.” The firm’s 18 investors expect to benefit from their clients’ commercialization, at which point Virtual will liquidate its equity stakes to pay shareholders dividends.

Virtual’s risk is actually less than that of traditional venture capitalists because it buoys clients with federal funding rather than its own cash. The firm expects to break even in 2004 and see significant profits in 3-5 years.

Goforth said it’s far easier to get Phase II SBIR money after documenting success at the first level. The Fayetteville native said his biggest confidence builder has been reassurances from SBIR panels that Virtual is “right on track.”

“Our success rate is three of eight on the proposals we’ve written, and that’s a great start,” Goforth said. “And of the five proposals that were initially rejected, we believe based on the reviews we heard back that several of those will be successful upon resubmission.

“The reviews keep saying things like, ‘innovative’ and ‘high potential.’ To me it’s clear that we’re going to be able to get a couple million dollars of money for each of these companies over the next couple of years.”

There are six companies in Virtual Incubation’s portfolio, five of which have made SBIR proposals. Two of those firms, NanoMech LLC and Vegrandis LLC, have actually received $305,000 in Phase I SBIR money. They stand to qualify for a combined $2.3 million at the next round.

But Goforth said due diligence is ongoing for five additional knowledge-based startups that could soon come into the fold. He plans to submit 50 total SBIR proposals this year.

During all of 2001, 22 SBIR proposals were made statewide in Arkansas. Virtual made 17 by itself in 2002, and has already equaled that mark in 2003.

“We’re trying to find diamonds in the rough that have a lot of applications,” Goforth said. “It’s got to be innovative. It’s got to have good market potential. It’s got to be protected by patents, patents pending or able to be quickly protected by patents. And it can’t be a completely done product because there would be no value in having it incubated.”

SBIR panels make awards throughout the year based on the potential of proposals.

University Partners

From universities and federal laboratories, Virtual licenses intellectual property (IP) that can be used to develop its clients. It’s called a ‘virtual’ incubator because unlike traditional business accelerators, such as the Genesis Technology Incubator in Fayetteville, companies don’t physically locate at the host. Goforth said future company branches will be located in markets such as Little Rock, where there’s university IP production but little infrastructure to support it.

The costs of licensing contracts varies widely from one university and deal to another. A typical package will include guaranteed royalties, an up-front fee and probably an equity stake for the university.

Johnny Stokes — director of the University of Arkansas’ Office of Research, Sponsored Programs & Technology Transfer — oversees the school’s IP licensing. He said Virtual has become a real force for getting knowledge-based firms off the ground.

“It helps the university in its mission to transfer technology and create economic development for the state,” Stokes said.

Ron Foster is director of Innovation Incubator, the UA’s small business accelerator. He said that Virtual has become “absolutely vital” to breaking the “bottleneck” of startups that previously never matured.

“The probability of a high-tech startup becoming competitive enough to get venture funding is one in 10,” Foster said. “Virtual is an integrated approach to help them get there.”

Mark Wagstaff, Virtual’s business development manager, said Goforth’s ability to organize projects as “win-win” propositions that make sense for everyone has put the company on the path to success.

Goforth, who has a bachelor of science degree in aerospace engineering from the University of Texas and a master’s and Ph.D. in mechanical engineering from Stanford University, said he got the idea to form Virtual after making his own startup mistakes. He founded a company called Vector that later sold to Artran in Springdale and learned how hard growing a company can be.

Model Change

Goforth said a change in emphasis at the UA, which he credits to the “high-level vision” of Chancellor John White, helped redirect Virtual’s focus early last year. He said the UA’s IP base has grown dramatically in recent years, and that so much promising research on campus has created a hotbed of development potential.

“The attitude at the university is that they truly want to be an economic development engine for the state,” Goforth said. “We felt like the timing was right, and we changed our emphasis from consulting work to actually creating companies.”

On Jan. 31, Virtual also converted from a “C” corporation to a limited liability company for tax reasons related to the model change. Goforth said the next piece of the puzzle that would ensure the growth of local knowledge-based business should be completed this year when The Alpha Fund finalizes its fund raising.

That entity will eventually be a $2 million-$5 million very early seed-stage fund that can cover some of the costs SBIR grants won’t such as IP protection.

“Our firms don’t need a lot of seed money, but they need a little,” Goforth said.

Virtual is in the middle of raising $500,000 in working capital, of which $125,000 is already firmly committed and Goforth said more is being considered.

That money will allow Virtual to get to the point where it can be self supportive, Goforth said.

“When we have five or more companies with their SBIR funding we’ll be self supporting,” Goforth said. “The advantage of investing in us right now is you get to participate in the eventual equity sales of all of our portfolio companies, current and future. So, one investment today provides participation in many different knowledge-based enterprises.”