(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/