SBIR/STTR Phase I vs II Accounting: Key Differences for Biotech and Deeptech Startups

SBIR/STTR Accounting: Understanding the Leap from Phase I to Phase II

Winning a Phase II Small Business Innovation Research (SBIR) or Small Business Technology Transfer (STTR) award is a major milestone for any deeptech or biotech startup. It validates your research and provides significant funding to advance your technology. However, the celebration is often followed by a jarring realization: the accounting and compliance requirements for Phase II are fundamentally different from Phase I. The relative simplicity of the first phase gives way to a new world of government contract compliance that demands rigor, process, and foresight. For founders managing finance in QuickBooks alongside a thousand other tasks, this transition can feel overwhelming. Understanding the shift from a fixed-price award to a cost-reimbursement contract is the first step toward building a compliant system that ensures you get paid and avoid costly audit findings.

The Foundational Shift: Fixed-Price vs. Cost-Reimbursement Contracts

The central accounting difference between SBIR/STTR Phase I and Phase II lies in the contract type. The answer to what changes is simple, but its implications are profound. Phase I contracts are typically Fixed-Price. This means you receive a predetermined amount of funding to achieve a set of objectives. If you complete the work under budget, your company keeps the difference. If you go over, the loss is yours. It's a straightforward arrangement that requires minimal financial reporting.

In contrast, Phase II contracts are typically Cost-Reimbursement. Under this model, the government does not pay you a lump sum. Instead, it pays for your actual, allowable costs incurred while performing the research. This means every dollar you spend must be tracked, justified, and categorized correctly according to federal regulations to be eligible for reimbursement. This shift moves the burden of proof entirely onto your company. You are no longer just responsible for delivering the research; you are responsible for proving that every expense claimed was necessary, legitimate, and correctly allocated. This is the one big shift that changes everything about your financial operations.

Cost Allocation and Phase II Indirect Cost Rates: What Can You Actually Bill?

Under a cost-reimbursement model, meticulous expense categorization is essential for government contract compliance for startups. Your costs must be segregated into two primary buckets: Direct Costs and Indirect Costs. Direct Costs are expenses that can be specifically identified with the SBIR/STTR project, like a scientist's salary for time spent exclusively on the project. Indirect Costs, or overhead, are shared business expenses necessary for operations but cannot be tied to a single project. This includes expenses like rent, utilities, administrative salaries, and your QuickBooks subscription.

To get reimbursed for these shared expenses, you must calculate an Indirect Cost Rate using a standard formula: Indirect Cost Pool ÷ Direct Cost Base = Indirect Rate. Your Indirect Cost Pool is the sum of all your allowable indirect costs, and the Direct Cost Base is typically the sum of your direct labor and materials. A scenario we repeatedly see is startups failing to properly categorize costs, leading to an inaccurate rate and lost reimbursement.

In your Phase II budget, a provisional indirect rate is proposed and used for reimbursement during the performance period. This means for every direct dollar you bill, you also bill a percentage for overhead. However, this is temporary. Crucially, the provisional rate is later adjusted to the actual rate after your fiscal year ends. If your actual rate was higher, you may be owed money. If it was lower, you might have to pay money back to the government.

Consider this breakdown for tracking SBIR expenses at a biotech startup:

• Lead Scientist Salary (100% on project): This is a Direct cost, as the labor is tied directly to project activities.
• CRISPR Reagents for Project X: This is a Direct cost, as the materials were purchased solely for the SBIR effort.
• Lab Facility Rent: This is an Indirect cost because it is a shared expense benefiting all company projects.
• Founder Salary (50% Admin, 50% Project X): This cost must be split. Labor allocation must be based on detailed time records.
• QuickBooks Online Subscription: This is an Indirect cost, categorized as a General & Administrative (G&A) expense.

DCAA-Compliant Timekeeping: Protecting Your Largest Expense

For nearly every R&D-heavy startup, labor is the single largest expense. In a Phase II contract, if your labor costs are deemed unallowable, the financial consequences can be severe. The agency often responsible for verifying these costs is the Defense Contract Audit Agency (DCAA), which audits contractor accounting systems. The DCAA’s standards are the benchmark for STTR grant financial management across most federal agencies.

The key to compliance is understanding that the DCAA focuses on the process, not the tool. A common misconception is that you need expensive software. The reality is that the DCAA audits a company's timekeeping process; it does not "approve" specific software. Your existing time tracking tool or even a well-designed spreadsheet can be compliant if it meets the core requirements.

A DCAA-compliant timekeeping process requires that:

1. Employees record their total hours worked each day, not just hours on the government project.
2. Time is recorded daily by the employee performing the work.
3. Hours are allocated to specific projects or overhead categories (e.g., 'Project XYZ', 'Business Development', 'Admin').
4. A manager reviews and approves the timesheet, typically at the end of each pay period.

The practical consequence tends to be that without this documented process, your labor costs are at risk. During an audit, if you cannot produce compliant timesheets, disallowed labor costs may need to be repaid. For a startup, having to repay months of salary expenses could be devastating. Implementing a compliant process before your Phase II project begins is one of the most critical SBIR accounting best practices. You can learn more in our time-tracking guide for practical implementation.

The Cash Flow Gap: Managing Government Reimbursement Realities

Moving from Phase I’s upfront payments to Phase II’s reimbursement model creates a significant operational challenge: managing cash flow. Reimbursement is not immediate. After you incur and pay for expenses, you submit a voucher to the government. This is where the cash flow gap emerges.

The government payment cycle for vouchers is typically 30 to 45 days after submission. This lag means your company must have enough working capital to cover all its expenses, including payroll and supplies, for a significant period before any cash comes back in. As a result, companies on a reimbursement contract must be able to float 6-8 weeks of operating expenses.

Imagine a deeptech company with a monthly operating burn of $80,000. In January, they spend that amount. They submit their voucher in early February. Given the payment cycle, they likely will not receive the reimbursement until mid-to-late March. In the meantime, they have paid for all of February’s expenses and are halfway through March. By the time the first payment arrives, they have floated over $160,000. This demonstrates why budgeting for federal research grants is as much about timing as it is about allocation. Underestimating this gap can stall R&D and create a predictable cash crunch.

Actionable Steps for Phase II Readiness

Navigating the transition from Phase I to Phase II is manageable with proactive preparation. The foundational work you do before the project starts is key to satisfying SBIR STTR grant accounting requirements and preventing future headaches.

1. Reconfigure Your Chart of Accounts. Before you incur a single Phase II expense, update your Chart of Accounts in QuickBooks. Create clear delineations between direct project costs and indirect cost pools like G&A and Fringe. This structure is the foundation of a compliant system.
2. Implement Compliant Timekeeping Immediately. Establish a DCAA-compliant timekeeping process. Train your team on the importance of daily, accurate time tracking and ensure managers understand their approval responsibilities. This single process protects your largest expense category.
3. Build a Realistic Cash Flow Forecast. Model the 30-45 day payment lag to understand exactly how much cash you need on hand to operate smoothly. This forecast will inform your decision-making and ensure your R&D progress is not halted by a funding gap.

By addressing these areas, you can focus less on financial compliance and more on the innovative research the SBIR/STTR program is designed to fund. See our Government Grants & Contract Accounting hub for more resources.

Frequently Asked Questions

Q: What's the primary accounting difference between SBIR/STTR Phase I and Phase II?

A: The main difference is the contract type. Phase I is typically a fixed-price award, where you get a lump sum. Phase II is a cost-reimbursement contract, where the government repays you for actual, allowable expenses you have incurred and documented, requiring a far more detailed accounting system.

Q: Do I need special "DCAA-approved" software for timekeeping in Phase II?

A: No. The DCAA does not approve specific software. It audits your timekeeping process. A system is compliant if employees record all hours daily, allocate time to specific projects, and have a manager approve their timesheets. Your existing tools may be sufficient if used correctly.

Q: Why is cash flow management so critical for Phase II awards?

A: Because Phase II operates on a reimbursement model, you must pay for all expenses upfront. With government payment cycles often taking 30-45 days, your company must have enough working capital to float nearly two months of operating costs to avoid stalling research while waiting for reimbursement.

Q: What happens if my actual indirect cost rate is different from my provisional rate?

A: At the end of your fiscal year, your provisional (estimated) rate is reconciled with your actual rate. If your actual rate was higher than the provisional one used for billing, the government may owe you money. If it was lower, you may have to repay the difference.