What You Need to Know About Mergers and Acquisitions Involving Government Contractors and Their Suppliers: Volume VII—Investing in Small Businesses

by Sheppard Mullin Richter & Hampton LLP
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Numerous government contracts programs support small businesses.  There are prime contracts set aside for various categories of small business entities.  Agencies have small business contracting goals and take them very seriously.  Prime contractors often are incentivized, through evaluation factors, to propose significant small business participation.  They can also face liquidated damages for failing to make good faith efforts to comply with their small business subcontracting plans.  These programs promote economic growth by incentivizing investment in small business entities.

The primary obstacle to investing in small businesses, from a government contracts perspective, is that it is quite easy to lose small business size status as the result of a corporate transaction.  The difficulties arise from the doctrine of “affiliation.”

The Small Business Administration (“SBA”) determines whether a contractor qualifies as a small business by examining whether its employees or gross receipts fall below a certain threshold, depending on the contractor’s NAICS code.  The SBA considers the employees or gross receipts of both the contractor and its affiliates.  In other words, the SBA treats the contractor and its affiliates as though they were a single entity by aggregating their employees or gross receipts when determining size status.

The SBA’s definition of affiliation is extraordinarily broad.  Two entities are affiliated if one controls, or has the power to control, the other or one or more third parties controls, or has the power to control, both.  SBA considers factors including ownership, management, previous relationships with or ties to another business, and contractual relationships in analyzing the issue of control.

Provided below are just a few examples of the circumstances under which SBA will find affiliation:

  • The investor owns more than 50% of the voting shares of the small business.
  • The investor owns a block of voting stock that is large relative to the next largest block of voting stock (g., 25% vs. 15%) of the small business.
  • The investor owns options that would allow it to acquire enough voting shares of the small business to meet either of the above conditions.
  • The investor controls the board of directors or has the ability to block a quorum of directors of the small business.
  • The investor has veto rights over any actions of the small business in the ordinary course (g., taking on debt, paying dividends, determining management compensation, etc.).
  • The investor populates the small business with its management and/or key personnel.
  • The small business is dependent on the investor for contracts, funding, or other support.

These are just a few examples intended to illustrate the breadth of the SBA’s affiliation rules.  There are many additional bases for affiliation.  The bottom line here is that acquiring any type of direct or indirect control over a small business will result in affiliation and, potentially, loss of that entity’s small business size status and the associated benefits.

Following a transaction that results in a change in size status, a small business is required to notify the relevant contracting officers.  Agencies are not required to terminate the contracts, but they can no longer count any funds spent on the contract towards their small business goals.  If the agency awarded the contract, in whole or in part, based on small business size status, there is a risk that it could terminate the contract for convenience or simply not exercise any future options under the contract.

Additionally, an entity that loses its small business size status as the result of a transaction is no longer eligible for small business set-aside contracts.  This may not be a significant concern if the contractor operates in an industry where most contracts are not set aside for small businesses, if the contractor offers a unique product or service, and if the contractor has a record of competing successfully against large businesses.  If, on the other hand, most of the contractor’s awards are small business set-asides and the contractor operates in an industry where most contracts are set-aside for small businesses, then a loss of small business size status could significantly impact the buyer’s valuation and, potentially, even the viability of the transaction.

The strategic implications of the SBA rules for government contracts mergers and acquisitions are extraordinarily complex.  But the key takeaways are relatively simple:

  • Large Businesses: Acquiring a small business will likely result in the loss of small business size status.  You need to consider how the loss of small business size status will impact sales.  Relevant diligence considerations include the percentage of contracts awarded to the target as small business set-asides; what percentage of the entity’s business is attributable to subcontracts predicated on its small business status, thus contributing to its prime contractors’ satisfaction of their small business subcontracting goals; the extent to which opportunities for large businesses exist in the target’s industry; whether the target offers unique solutions that cannot be obtained from other contractors; and the target’s record of success competing against large businesses.
  • Small Businesses: Potential buyers will want to know how a loss of small business size status will impact your revenue.  Position yourself to make a compelling argument that the impact will be minimal.  Go outside your comfort zone.  Compete with large businesses – and win.  Articulate your value proposition independent of your size.
  • Private Equity Firms:  It is possible to invest in small businesses without jeopardizing their small business size status.  But this is extremely complex and requires structuring the transaction with extreme care.  If you keep the small business size status, you cannot have control.  This necessitates an extraordinary level of trust in the controlling shareholder(s) – and a way to liquidate your investment if the relationship sours.

Small businesses will often appear at first glance to make attractive candidates for investment.  However, the extent to which the entity’s past and future success is dependent on its size status can mask significant downstream risk to the company’s cash flow.  Understanding the impact of the SBA’s affiliation rules on a corporate transaction is essential to effective due diligence in this realm.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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