Is Government Funding Good for Your Startup?

Luke Sykora, Stanford University July 3, 2019

As an Air Force Captain charged with distributing R&D money to private companies, Jason Rathje observed plenty of overlap between the innovations that the military, industry leaders and academic institutions were pursuing. He even helped create a consortium to bring these groups together. Still, he found that the set of firms interested in partnering with the government was often surprisingly narrow. Which made him wonder: What was holding companies back from pursuing relationships with the government?

“I went around and interviewed a bunch of VC groups,” he says as he sits in a Stanford coffee shop nursing a mid-afternoon coffee. “And they told me: ‘If you’re a startup, one: Don’t ever have the government as your first customer. And two: Only go to the government after you have a complete product to sell.’”

Clearly, the sense from Silicon Valley venture capitalists was that early-stage startups had more to lose by partnering with the government than they had to gain. But given his experiences funding private firms from the government side, Rathje suspected that the actual picture was more complicated.

Government funding sometimes offers more than just money, including access to advanced national laboratories and internal government information.

To dig into quantitative data about public-private partnerships, Rathje came to Stanford University’s Ph.D program in Management Science and Engineering. Working with his advisor Riitta Katila, a professor of Management Science and Engineering, he focused his research on how governments and private companies (particularly startups) interact when pursuing technological innovation. Here’s what we already know:

  • Government and private companies have worked together to advance recent technologies like autonomous vehicles (Ford engineers David Hall and Jim McBride introduced rotating lidar in 2005 via DARPA’s Grand Challenge).
  • Government funding sometimes offers more than just money, including access to advanced national laboratories and internal government information.
  • Government funding often leads to more government funding, and can result in firms that are less engaged with the broader commercial market.
  • “Mission-based” agencies like the Department of Defense and NASA — which have significant purchasing power — can serve as the lead market for new technologies.
  • Recently, companies in sectors like AI (Palantir) and private space exploration (SpaceX) have been able to leverage early government funding to find competitive advantages and simultaneously grow both public and private business streams.

Measuring the Effects of Government Funding

So when is it a good idea for a young firm to pursue government funding? In a recent working paper, Rathje set out to investigate how public-private R&D partnerships affect innovation, in particular.

Innovation might, on the surface, seem like an easy thing to measure, but it’s actually quite difficult. Innovation isn’t a linear path, and a technology that seems revolutionary in a cultural sense can be very simple on a technical level.

Public-private R&D collaborations that emerge from government grants tend to produce more disruptive invention than private firms inventing on their own.

To map innovation, Rathje turned to one of the few massive and — crucially — interlinked datasets that captures technical innovation: patents. Individually, a patent is a description of a single unique invention. But almost every patent cites previous patents, and is in turn cited by subsequent patents, sometimes hundreds of them. The result is a complex web that serves as an imperfect but useful map of how technology advances.

Examining US patent data from 1982 to 2012, he studied over 33,000 patents that resulted from public-private R&D collaborations. He then analyzed the data by tracking patterns in patent citations, an accepted standard for determining the nature of the emergent technology.

Two of his findings, in particular, will catch the ears of early-stage startups:

  • Public-private R&D collaborations that emerge from government grants tend to produce more disruptive invention than private firms inventing on their own.
  • Public-private R&D collaborations that emerge from cooperative agreements lead to more impactful innovation than a private firm acting on its own.

Impactful technologies, Rathje explains, generate direct market value. A disruptive technology, on the other hand, radically changes the technological field and makes previous technology effectively obsolete.

A simpler way to think about it: When you’re pursuing an impactful technology, your goal is to design a more effective ball. A disruptor, by contrast, is proposing an entirely new kind of ball that will require changing the rules of the game.

Government funding comes in many forms, but much of Rathje’s research focuses on the implications of three sorts of R&D funding: grants, cooperative agreements and contracts. Each type of relationship, he finds, has important implications for companies that partner with government funders.

Disruption: Granted

If you’re imagining an aspiring disruptor as a lone figure with a singular, novel view of the future, think again. In actuality, disruptors often travel in packs.

“Even in nascent markets, everybody has competitors,” says Rathje. There are always a few players swirling around the same opportunity, working on similar products and approaching the problem in similar ways. In academic circles, that’s called “isomorphism” — the tendency of companies in a particular ecosystem to gravitate toward similar solutions.

And that, Rathje finds, is where government grants can be useful. “Instead of, ‘How can the government fund what I want to do?’, it’s: ‘How can I engage with the government to do something different?’” he observes.

Grants tend to emerge from science organizations like the National Science Foundation and the National Institute of Health, and focus on reporting scientific results rather than delivering fully realized products. “When you fund science, there’s a lot less restrictions,” Rathje observes. Beyond the required reporting, there are no concrete deliverables.

Because they’re geared toward scientific exploration rather than commercial product development, a common misperception is that most grant opportunities go to research institutions rather than private firms.

The reason grants tend to generate novel, disruptive inventions, Rathje suspects, is because of that very scientific autonomy. Companies can tailor their scientific research to explore concepts beyond the scope of their core day-to-day business, coming up with inventions that might propel their own business in the long run, and also potentially open up entirely new technological streams.

Because they’re geared toward scientific exploration rather than commercial product development, a common misperception is that most grant opportunities go to research institutions rather than private firms. Yes, research institutions make heavy use of government grants, and we’ve certainly seen many disruptive inventions come from universities. A NASA-funded 1989 California Institute of Technology patent for a fiber optic voice/data network perfectly illustrates what grant-funded disruptive technology looks like. The patent itself speaks to the limited use cases for the technology at the time, describing it as “an asynchronous, high-speed, fiber optic local area network originally developed for tactical environments with additional benefits for other environments such as spacecraft, and the like.” Fast forward 25 years, and fiber optic LAN networks weren’t uncommon on college campuses and offices. But a company trying to commercialize that technology in the early 1990s would have been decades too far ahead of the curve.

In actuality, many companies also receive government grants. Only companies are eligible for the Small Business Innovation Research (SBIR) program, for example, which primarily funds companies via grants and distributes around $2 billion dollars each year to small businesses in the US.

“Grants can range from pretty small to pretty large,” Rathje observes. Even within a single funding program, awards can differ greatly. The smallest 2018 award for the U.S. Geological Survey’s 3D Elevation Program was about $23,000, while the largest was just over $1 million.

But companies rarely pursue a single government-funded project in isolation. In 2015, the Los Angeles Times reported that Elon Musk’s three companies — Tesla, SolarCity and SpaceX — had collectively pulled in $4.9 billion dollars in government support (meaning grants, but also things like tax breaks and discounted loans).

Making an Impact

Cooperative agreements are similar to grants, but involve additional layers of government oversight and participation. A blog lays out the basics: “In a cooperative agreement…federal employees participate more closely in performing the program. When you read ‘cooperative,’ think working ‘side-by-side.’”

In some cases, government partnerships provide the sort of advanced “smart capital” that even the most specialized VC firms won’t be able to supply.

In these cases, there’s less autonomy, but cooperative agreements generally mean gaining more access to government technology and expertise, which can provide a competitive advantage. “It’s a government smart capital play,” Rathje says. In some cases, government partnerships provide the sort of advanced “smart capital” that even the most specialized VC firms won’t be able to supply.

“I love the national laboratory system,” Rathje says, pointing to places like the Lawrence Livermore National Laboratory, which hosts the world’s second-most-powerful supercomputer.  “I think they are an amazing resource. Engaging in these cooperative agreements is a great way to gain access.”

In his dataset, a Photon Energy, Inc. patent for a thin-film photovoltaic device — developed in partnership with the Department of Energy — is a classic example of an impactful technology. It cites a significant body of previous work, including numerous Texas Instruments patents, and is in turn cited in over 100 subsequent patents. In other words, it’s an important incremental advancement in solar power.

“The research shows very clearly: If new technologies actually come out of the cooperative agreement they’re way more impactful,” observes Rathje. “And, with respect to other partnership types, companies have a much more direct path to commercialization.”

A Contract to Innovate

The government uses contracts to purchase goods and services, which doesn’t sound much like a research and development activity. But sometimes, especially when a government agency is interested in bringing an immature technology into production, it will issue a “cost-plus” contract. These sorts of contracts cover the cost of development, plus a fixed profit margin that maxes out at 15%. (Not a very exciting margin in the world of high-risk technology R&D project, Rathje points out. Plus, the government often claims intellectual property rights in these cost-plus contracts.)

Young firms with an actual product or service to sell might also pursue a simple procurement contract, and use that revenue to fund further growth. This is the preferred arrangement of “mission-based” entities like NASA and the Department of Defense. The margins on such contracts can be much larger, Rathje finds, but they can also be risky for startups trying to quickly innovate and scale.

“If you’re a startup, the DoD or NASA can be really interesting resources, both in terms of money and technical talent,” he says. “But if you’re a young firm and you devote your internal resources to their needs, you could be limiting your ability to allocate those resources to other opportunities.”

In one paper that he’s working on, he spoke to a start-up that won a NASA contract for extraterrestrial imagery analysis. “And they said: Looking back on it, we should have never taken the contract,” Rathje says. “It took them 30% off of their target in terms of their R&D strategy.”

The Big Question: What About Growth?

As funders, VC firms are powerfully motivated to help companies grow — IPOs and acquisitions are what make their investments pay off. In the case of the government, on the other hand, the goal might be to pursue exploratory research or to purchase equipment, but the goal is rarely to directly promote the health and growth of private companies.

“The company needs to scale along with the technology.”

And yet, Rathje argues, a government mindset that thinks more about private company growth could create a more robust and sustainable ecosystem for public-private innovation. “The company needs to scale along with the technology,” he says.

Last year, Rathje’s own Air Force working group partnered with the Air Force’s SBIR program to implement a new, commercially-oriented approach to innovating with companies. In less than 9 months, they awarded $80 million to private firms. “What I’m dealing with in my Air Force job is: How do we deploy some of this in the DoD to get around some of these things that are detrimental to firm growth?” Rathje says. “How do I implement changes in my world to better adapt to the environment in the commercial sector?”

So far, that strategy has meant incentivizing fund matching and pursuing products and services that are useful beyond just the government, so companies don’t need to stretch their R&D so far to fit the government’s specifications. “They can get more money from us if they bring in other partners: a VC, or another government funder, private equity, etc.,” he says. “And rather than developing an exquisite solution just for us, we maybe want to use something that’s available commercially, and just deploy it differently.”

His perspective suggests one final question to ask of a potential government funder: How much are you thinking about my own company’s growth? If the government partner understands and supports that imperative, then aligning your R&D priorities with the government’s needs becomes much easier.

Visit the STVP Research page to learn more about the STVP PhD program, which focuses on the study of entrepreneurship and innovation within technology-based companies.