On November 1, 2016, the U.S. Small Business Administration implemented new rules which could impact the ability of small business contractors to exit their businesses.
Traditionally, one exit strategy available to small business contractors has been to sell to acquirers including private equity firms and other strategic buyers. Professional IT service firms under the NAICS 5415 and 5416 codes, in particular, could grow to $20 plus million a year revenue businesses and exit by selling to a private equity firm or strategic buyer who could add the revenue and earnings to the bottom line for the balance of the contract period.
This opportunity may be more limited going forward because acquirers, including private equity firms and other strategic buyers, will need to evaluate the impact the acquisition and the new small business subcontracting rules may have on the sustainability of the target company’s government business. Acquirers of a company that identifies itself as a “small business” under the SBA regulations should consider the potential impact of the new regulations under the key FAR provisions amended by the Final Rule: FAR Subpart 19.7 (The Small Business Subcontracting Program) and the contract clauses at FAR 52.219-8 (Utilization of Small Business Concerns) and FAR 52.219-9 (Small Business Subcontracting Plan).
While the impact of these regulations is unclear, the rule changes serve as a reminder to small business contractors that they should partner with people who understand the SBA affiliation rules. Many small businesses may need to buy exiting small business firms to offset that potential decline in acquisition demand from traditional acquirers.
New SBA regulations may significantly increase recertification transaction costs associated with a merger or acquisition for traditional acquirers including private equity firms and other strategic buyers.
The new SBA regulations impose additional recertification requirements on a small business concern if a merger or acquisition occurs after the small business concern submits its proposal but prior to contract award.
In determining whether affiliation exists, the SBA considers the totality of the circumstances and may find affiliation even in circumstances where no single factor alone may be sufficient to constitute affiliation. The acquirer may try to structure the transaction with the small business government contractor in a manner to avoid affiliation, such as by having the target retain majority ownership and management control of itself.
Often, however, the target and the acquirer will be deemed to be affiliates, and the target will no longer qualify as a small business under the SBA’s regulations. This is because the spirit of agency policy wants the contracts set aside for small businesses to truly be performed by small businesses. Therefore, traditional acquirers including private equity firms and other strategic buyers will likely spend inordinate time and resources advocating a size determination with the agency only to have the agency conclude there is affiliation.
While this uncertainty and additional transaction costs may lower purchase prices and dampen demand from traditional acquirers including private equity firms and other strategic buyers, it could mean an enormous buying opportunity for small businesses who are looking to establish qualifications through business acquisition and stand ready to realize the true value of the target purchase price.
By definition, it is far easier and less costly to satisfy re-certification requirements post-acquisition if a 100% women-owned sole proprietor is buying an exiting women-owned sole proprietor or a Service Disabled Veteran Owned Small Business (SDVOSB) partnership is selling to a two-year old SDVOSB partnership. Small business contractors should target acquisition very early in their business history to take advantage of this development.
New SBA regulations may mean agencies are less motivated to award future business — including exercising options or placing orders under existing contracts — to the contractor acquired by traditional acquirers including private equity and other strategic buyers.
Following a merger or acquisition resulting in a change in size status, the small business must notify all contracting officers for its outstanding bids and proposals and existing contracts and make updated representations regarding its size status. Generally, the target will retain its status as a small business for the life of its existing government contracts, and the change in size status will not change the terms and conditions of the contracts. The target will be permitted to complete its performance on its existing small business set-aside contracts. However, once the target recertifies that it is no longer a small business, the contracting agencies will no longer be permitted to count additional orders placed with, contract options exercised with, or modifications issued to that contractor towards the fulfillment of the agencies’ small business procurement goals. In other words, the agencies will not be entitled to receive small business credit for such orders or contracts.
As a result, agencies may be less motivated to award future business — including exercising options or placing orders under existing contracts — to the contractor. The contractor also will no longer be eligible for participation in future procurements reserved for small businesses. Similarly, prime contractor customers will no longer be able to consider contract extensions or modifications of the target’s subcontracts towards meeting their goals under their small business subcontracting plans, and may be less motivated to continue doing business with the target company following the loss of the target company’s status as a small business. Thus, the value of a small business target and the overall sustainability of its government contracts business could decrease dramatically after size recertification and loss of small business size status.
Uncertainty about the value of a small business target purchase price due to the uncertainty surrounding small business affiliation determination may mean that exiting small businesses do not realize the fruit of all their labor. Absent traditional buyers who may see fewer targets worthy of investment, exiting small business contractors would ordinarily be forced to realize smaller valuations because traditionally small business acquisitions have been structured as earn outs due to insufficient cash on hand to support a multiple of 3-to-5 times EBITDA. In addition, banks traditionally have been reluctant to support purchase prices over and above $1-2 million for businesses with greater than $500,000 in goodwill. Therefore, small business contractors should look to partner with banks that understand small business affiliation standards, understand the true value proposition of government contracts, and are prepared to finance acquisitions from $1 million to 10 million in purchase price.
Conclusion – Small business contractors should target acquisition earlier in their business history.
Acquirers and their advisors should be mindful of the revisions to the FAR small business regulations during the due diligence process, particularly where the acquisition involves a target company identifying itself as a “small business.” The transaction may expose the target company and its parent company to new subcontracting plan requirements, along with additional notification, reporting and compliance obligations. More broadly, the new FAR small business subcontracting rules may impact the value and sustainability of the target company’s government business for traditional acquirers including private equity firms and other strategic buyers but likely means exiting small business contractors will need to sell to small business acquirers.