On June 25, 2019, we wrote about proposed changes to the method for calculating size eligibility for small business set-aside contracts. This is the first in a series of articles exploring the proposed rule's specific impacts on federal government contractors.

The U.S. Small Business Administration (SBA) recently issued a Proposed Rule implementing the Small Business Runway Extension Act (the Act). The proposal changes the calculation of a firm's average annual receipts for purposes of determining eligibility for contracts set aside for small businesses. Under the current rule, the SBA averages a company's annual receipts for the preceding three years in order judge whether the company qualifies as a small business or has exceeded the applicable size standard. If implemented, the Proposed Rule will expand the look-back period to five years. Companies wishing to comment on the Proposal have until August 23, 2019.

This article examines the effect of the Rule on transactional work involving government contractors.

Summary of the Proposed Rule's Impacts

The SBA's size standards establish eligibility for a variety of federal small business assistance programs such as the SBA's 8(a) Business Development (BD) program, the Historically Underutilized Business Zones (HUBZone) program, the Service Disabled Veteran-Owned Small Business (SDVOSB) program, the Woman-Owned Small Business (WOSB) program and the Economically Disadvantaged Woman-Owned Small Business (EDWOSB) program. The size standards use annual receipts to determine eligibility for some industries, and use number of employees for others. The Proposed Rule does not change the calculation method for employee-based standards.

By changing the calculation period from average annual receipts from three to five years, the SBA seeks to allow mid-sized businesses who have just exceeded size standards to regain their small business status, and for advanced small businesses close to exceeding the size standard to retain their small business status for a longer period.  This chart illustrates the impact of an elongated measurement period, assuming a $90.00 size standard:

In this example, the company remains under the size standard if using a five-year average, but exceeds the standard when using a three lookback. However, it should be noted that the converse is also true: The longer averaging period may cause some small businesses to exceed their applicable size standard where the business may have enjoyed particularly good years within the five-year period. After estimating the number of potentially affected contractors using 2017 data, SBA concluded that 1700 contractors would see a positive effect of either becoming small firms or extending the period in which the firms remained small  An estimated 498 companies would lose their size status as a result of the change.

Impact on Transactional Work

Among the Proposed Rule's impacts are potential changes to prime and subcontractor relationships and acquisitions and financings of government contractors. Most immediately, the amount of time that a prime contractor can include a small business in the prime's calculation of its small business spend for purposes of its Small Business Subcontracting Plan could be shortened or lengthened. For this reason, if not already included, prime contracts should contain a clause requiring all subcontractors – not just small business contractors --to advise the prime of a change in their size status. A prime contractor might not otherwise realize that one of its subcontractors had regained small business status and could therefore be included toward meeting the prime's small business subcontracting goals.

The change to a five-year averaging period also potentially affects the acquisition of small business federal contractors. In publishing the Proposed Rule, the SBA explained the distinction it makes between corporate divisions and corporate subsidiaries. SBA's position is that a division's revenue is part of the concern in which it sits. Even when a division is sold, its revenues remain a part of the concern selling the division's annual receipts for purpose of calculating its size. The acquiring company will not include the division's prior receipts when calculating its annual receipt figures.  In contrast, where a concern acquires an affiliate during the measurement period, the annual receipts of the affiliate are included for purposes of determining size for the entire period of measurement – not just the period after the affiliation arose. By the same token, the annual receipts of a former affiliate are excluded from the size calculation if the affiliation ended before the date used for determining size and the exclusion applies during the entire measurement period.

The Proposed Rule will impact corporate combinations in multiple ways. The most obvious impact will occur if one small business acquires another small business and the combined company remains small under the applicable size standard. The combined company may remain small for a longer period if a five-year period is the basis for the size calculation, perhaps providing an increased revenue stream after the acquisition. Similarly, if a small business acquires a division from another company (as opposed to a subsidiary), and the combined company would otherwise exceed the applicable size standard, the combined entity may be able to remain small for a significant period of time because the division's past revenues for the past five years would not be included in the acquiring business' average annual receipts. In contrast, in an acquisition of a wholly-owned subsidiary the subsidiary's past receipts would be attributed to the acquiring company. These distinctions should figure into decisions about transitioning out of the small business program, acquiring a small business or providing a loan to a small business.

Key-Take Aways

Once implemented, the five-year lookback will impact small businesses in a number of ways. Contractors need to be aware of the impacts on a prime contractor's Small Business Subcontracting Plan. Small businesses seeking to grow will need to analyze the potential effect on its small business exit strategy.