(FORTUNE Small Business) -- Competing for federal grants can make a small-business owner feel as if she has stepped into a Tom and Jerry cartoon. Larger, better-funded firms are always ready to pounce on little guys and snatch their tiny portion of the government cheese. What's worse, some politicians have now decided that it's Tom who needs some help. The U.S. House has passed, and the Senate is considering, legislation that would dramatically alter the definition of "small" business and expand access to set-asides now reserved for independent entrepreneurs. The bill's Orwellian title: the Small Business Investment Expansion Act.

Today, by law, 11 federal agencies earmark 2.5% of their R&D budgets for grants meant to encourage innovation among small businesses. Qualifying companies must have no more than 500 employees and be "independently owned and controlled," which the SBA defines as 51% owned by individuals rather than other businesses, such as venture capital partnerships. That means some VC-backed firms are locked out of the Small Business Innovation Research program, which is up for reauthorization. Using the 2.5% set-aside funds, SBIR offers about $2 billion each year in small grants to high-tech firms, in three phases. The first two rounds, with grants as large as $750,000, are reserved for small businesses. In the third round, applications from entrepreneurs funded by large VCs and other corporations are accepted.

When venture capitalists hate your company

Naturally, VCs believe their portfolio companies should qualify in all phases. They are lobbying to end the rule by which the SBA counts all employees of any company "affiliated" with the applicant - including the VC firm and other startups in its portfolio - toward the 500-person limit. The VCs' argument focuses on biotech. Developing a new drug or medical device is so costly that it rarely happens without big outside investment. Mark Heesen, president of the National Venture Capital Association, says the rules limiting VC-backed participation in small-business programs force the National Institutes of Health, for example, to give its SBIR funding to the least promising startups. "Venture capitalists," he says, "have funded well over 90% of all the biotech firms in the United States."

But Jere Glover, an architect of the SBIR program who now directs the Small Business Technology Coalition, disagrees. He argues that SBIR grants resemble the early "angel" funding that helps a promising business get started, before the stage at which the more risk-averse VCs are ready to invest. SBIR awards about 5,000 grants each year, compared with only a few hundred deals closed by the VC industry. If VC-backed companies were allowed to compete for SBIR funds, Glover fears, they could submit polished proposals for larger grants and reduce the number of small firms that benefit.

Fred Abramson, a biotech entrepreneur who also teaches at Johns Hopkins, might seem a natural advocate for VC-backed companies - but he vehemently opposes the rule change. His firm, Alphagenics, is preparing a product that will allow consumers to learn about their personal genotype. Abramson recognizes that accepting venture capital might cost him access to federal R&D dollars - but that's fine with him. "We're out talking to potential backers, some of whom are in the VC community," he says. "Assuming that we get the funding we want and need, we will probably wind up ineligible for many of these programs. That goes with the territory. The notion that if you raise $30 million and you're no longer eligible for something, it's a punishment - that's absurdity."

Pentagon R&D spending skyrockets

While the current debate is focused on R&D grants, changing the definition of "small business" could affect a wide range of programs, from subsidized small-business loans to fast-track procurement rules for smaller federal suppliers, all of which refer to the SBA's complex industry-by-industry definition of "small." If legislators aren't careful (or try to quietly deliver more favors for their corporate campaign contributors), they could set off a chain reaction that would allow larger firms to qualify for many small-business assistance programs - at a time the SBA says it is focused on culling from its rosters big businesses posing as small ones.

The White House, where any bill redefining small business would ultimately need to pass muster, says it opposes the redefinition effort. "Not only would this change be inequitable for actual small businesses," according to a statement from the Office of Management and Budget, "but it would be a step backward from our recent progress in addressing the misidentification of large firms as small businesses for federal procurement purposes." Either way, something must happen soon: The SBIR program is slated to expire on Sept. 30. If Congress doesn't act by then, agencies may be prohibited from awarding grants already budgeted.

Some might ask, Who cares? There is a strong libertarian streak among entrepreneurs, most of whom get no help from Washington and expect none. Yet billions of their tax dollars are used to underwrite all manner of subsidies and loopholes for big corporations and other well-connected interest groups. That's the system we've got, like it or not. It's hard to fault the independent owners of small tech companies - a major source of innovation in today's economy - who are asking the VCs and their political supporters to keep their hands off this one crumb that fell from the $147 billion federal R&D buffet.

First Published: April 11, 2008: 12:32 PM EDT

Source: http://money.cnn.com/2008/04/03/smbusiness/pretending_small_SBIR.fsb/

Efraim Diveroli, the 22-year-old Miami Beach arms dealer, is already under investigation for allegedly selling banned Chinese munitions to the U.S. government.

Now Diveroli's firm, AEY, is being singled out as an example of fraud and mismanagement in how the federal government awards contracts to small and minority-owned businesses.

Sen. John Kerry, chairman of the committee on Small Business and Entrepreneurship, said AEY won as many as 50 contracts worth $298 million, in part because of its designation as a small disadvantaged business -- a status reserved for people belonging to certain minority groups who can prove their net worth is under $750,000.

There's no evidence that AEY ever asked for the special status or would have been eligible. Diveroli's grandfather is Italian -- not one of the minorities singled out under the program.

The incident sheds light on what some business advocates contend are efforts to inflate contracting numbers in order to exaggerate the government's commitment to small and minority-owned firms. Since 1995 there have been 13 government investigations and two private studies that have turned up abuse and mismanagement in the federal contracting system.

Kerry sent letters to the Department of Defense, the State Department and the Small Business Administration Thursday asking about the error.

''Lack of oversight of contracting programs within the federal government is allowing companies like AEY Inc. to erroneously access hundreds of millions of dollars in contracts as an SDB,'' Kerry wrote to SBA Administrator Steven Preston. The lapses are ``undermining a program created to level the playing field for small disadvantaged businesses.''

The SBA in Washington says it has no record that AEY ever applied for SDB status.

AEY would not comment, and Diveroli's lawyer did not immediately return calls.

A review of the Federal Procurement Data System, which provides information on government contracting, found AEY was first identified as an SDB in June 2006 by the State Department and Army. It ultimately received the SDB designation 33 times on contracts worth $224 million. The company received another 19 awards during the same period without being labeled an SDB.

In the past, government auditors have blamed such errors on ''miscoding'' and typos.

''That's the same excuse the government has been using for the last six years,'' said Lloyd Chapman, president of the American Small Business League, which follows contracting issues. ``It's not accidents, it's not data entry errors, it's a well-orchestrated attempt to misrepresent the volume of contracts that go to small businesses and minorities.''

The government has the goal of channeling 23 percent of all contracts to small firms and 2.5 percent of contracts to SDBs. SDBs are usually owned by blacks, Hispanics, Asians or Native Americans. Other ethnicities can qualify only if they show a ''preponderance of evidence'' that they are disadvantaged.

While the government routinely misses its small business goal, it has done better hitting the SDB target.

In fiscal 2006, the most current year available, SDBs won $23 billion worth of contracts, or 6.8 percent of all government contracts.

But Chapman said there's evidence those figures are bloated with firms like AEY.

''For everyone that's caught there are hundreds that get away with it,'' he said.

Similarly, a 2005 investigation by The Miami Herald found that of the top 20 small-business contractors in Florida, more than half exceeded the SBA's basic definition of a small business.

AEY hit the news last month when an Army contract worth up to $300 million was suspended after it was discovered the company was allegedly passing off aging Chinese-made ammunition as Hungarian.

The bullets were destined for Afghanistan, but the transaction may have violated a ban on sales of Chinese munitions to the U.S. government. Now Diveroli is under criminal investigation and expected to appear before a congressional committee later this month.

''Faulty contracting procedures and deficient safeguards are no excuse for putting troops in Afghanistan and Iraq in greater danger,'' Kerry wrote. ``The Bush Administration needs to explain how and why this mistake occurred . . . and what steps they are taking to make sure that it never happens again.''

Source:  http://www.miamiherald.com/business/story/491358.html