Small Business Recertification Rule Creates Uncertainty for Emerging Companies in U.S.
December 4, 2007
In an effort to close a perceived loophole in existing government contracting regulations, the U.S. Government recently imposed a new small business recertification rule for companies that do business in the federal marketplace. The new rule impacts contractors who rely upon small business set-asides and more importantly increases uncertainties for companies interested in merging with or acquiring government contractors that depend on small business benefits.
Background: The Competitive Advantage of "Small Business" Status
An attractive aspect of doing business with the U.S. Government is its avowed policies intended to maximize the opportunities for "small businesses" to participate in the contracting process. These policies are enforced through annual small business contracting goals established for each Government department and agency which, in turn, spur them to create contracting opportunities limited to qualified small businesses. Most notable of the programs are the numerous contracts that are set aside for small businesses generally or for those that fall into various economically or socially disadvantaged categories. In addition, large companies awarded significant contracts are required to establish small business subcontracting plans under which they are expected to award a percentage of work to small businesses.
Although many government contracts are awarded for a period of from one to five years, Multiple Award Schedule (MAS) contracts (e.g., GSA Schedule contracts), Multiple Agency contracts (MAC), and Governmentwide Acquisition contracts (GWAC), which generally include awards to small business entities, are usually awarded for base periods of up to five years with up to four additional five-year option periods. With their favored status and potential income stream, particularly under these long-term contracts that can last for up to 20 years, small businesses become attractive acquisition targets for larger entities that desire to buy into a revenue stream from which they are otherwise precluded.
The Government traditionally determines small business size eligibility based upon a revenue-based or number-of-employee-based formula that is applied to industry classification size limitations. Thus, each contract in which size considerations are a factor will specify the industry classification for the proposed work and the maximum size of an entity that may qualify for the contract. Entities desiring to bid on the work must certify that they qualify under the applicable size standard for the contract work. The challenging aspect of this process for businesses is that entities are required to apply broad "affiliation" rules that include in its size calculation the revenues / employees of any entity with which it is affiliated through management, contract, debt, common interests, or other forms of dependency where one entity has the power to control or influence another. Competitors and the Government can challenge a contract award to an entity they believe to be other than small. The affiliation rules are intended to preclude large entities from taking advantage of benefits intended for small businesses.
Until recently, once a small business was awarded a set aside contract it need not reestablish its size qualification for the duration of the contract. For MAS, MAC, GWAC, or other long-term contracts, the contract duration could be as long as 10 to 20 years, even though the entity had long outgrown its small business size standard through internal growth or through its acquisition by another entity. As a result, much of the contract revenues intended for small businesses went to large entities which had acquired smaller entities with a valuable portfolio of set aside contracts.
Contractor and Investor Beware: Recertification Rules Have Changed
This past summer, to rectify what was perceived as undesirable loopholes in the small business program, the Government imposed stricter certification rules intended to more accurately reflect the size of contractors engaged in government business. Now, contractors holding long-term contracts are required to represent their size status on contracts prior to the end of the fifth year and then prior to exercising any option thereafter. In addition, contractors must represent their size status following any merger or acquisition and following their entering into a novation agreement by which they transfer a contract from one entity to another entity. Finally, as the U.S. courts have consistently upheld in recent years, and as is now reflected in the contracting regulations, a government contracting officer can require an entity to recertify its small business size at any time, which typically may occur at the Government's exercise of a one-year option or with the award of a new order under a contract. In this regard, the application of the "affiliation" rules can mean that the acquisition of less than 50% of a small business can result in an entity being considered affiliated with a larger entity for small business certification purposes.
Consequences of the Rules Change for Contractors and Investors
There are several consequences to these rule changes. From a contractor's perspective, one must understand that upon its submission disclosing it is no longer small, an entity may no longer claim small business benefits for future opportunities in that industry category. In addition, Government agencies may no longer claim under their small business goals a contract held by an entity that outgrows its small business status. Although an agency need not terminate such contracts, it has the right to do so. It may also elect not to exercise an option. Thus, with more frequent recertifications, small entities face greater risk that they will lose more quickly the protected revenue stream they previously enjoyed. Moreover, entities that have not prepared for their emergence into the general contracting world often face daunting challenges in competing against larger and more sophisticated entities.
From an investor's perspective, the regulatory changes herald greater uncertainty for the acquisition market for emerging entities holding seemingly lucrative set-aside contracts. The revenue stream that once made these companies attractive should now be viewed with greater caution. The target entities should probably undergo greater due diligence to assess the basis of and future value of any transaction based upon their government work. Deals will need to be approached with greater sensitivity to the potential impact of government regulations. That said, with careful assessment and sound advice about the government market, there are likely to be numerous well structured and well managed smaller entities that may well prove to be a valuable asset even if they no longer qualify for small business status.