SMALL BUSINESS ISSUES IN GOVERNMENT CONTRACTS MERGERS & ACQUISITIONS. By Daniel E. Chudd and Damien C. Specht

This material from Briefing Papers has been reproduced with the permission of the publisher, Thomson Reuters. Further use without the permission of the publisher is prohibited. For additional information or to subscribe, call 1-800-344-5009 or visit http://legalsolutions.thomsonreuters.com. Briefing Papers is now available on Westlaw. Visit westlaw.com BRIEFING PAPERS SECOND SERIES practical tight-knit briefings including action guidelines on government contract topics SMALL BUSINESS ISSUES IN GOVERNMENT CONTRACTS MERGERS & ACQUISITIONS By Daniel E. Chudd and Damien C. Specht Mergers and acquisitions are part of the normal corporate life cycle. For companies that hold Government contracts, however, a change of control or taking on a minority investment may include special risks and unique pitfalls. For buyers, Government contractor investments require tailored diligence to avoid significant future liabilities and the potential loss of ongoing Government contracts. 1 Although Government contracts transactions worth hundreds of millions of dollars grab the headlines, the majority of Government contracts acquisitions involve small businesses. Third parties report that more than 80% of transactions in this space were below $50 million in 2013, and a comparable percentage is expected in 2014. These statistics are not surprising. The Government contracts industry includes a large number of closely held small Avoiding Affiliation In The Letter Of Intent Small Business Diligence Identifying Set-Asides Evaluating Manufacturing Contract Compliance Evaluating Services Contract Compliance Assessing The Value Of Current Set-Asides Socioeconomic Program Transfer Rules Multiple Award Contracts The Purchase Agreement IN BRIEF firms. These small businesses can provide a buyer or investor with targeted client access, as well as an efficient way to acquire specific intellectual property or desirable management personnel while limiting organizational conflict-of-interest risks. 2 Although they are quite common, mergers and acquisitions involving small Government contractors implicate a number of regulatory concerns. Failure to recognize these issues may jeopardize contract eligibility, lead to contract Minority Investment Issues Post-Acquisition Issues Conclusion Daniel E. Chudd is a partner in Jenner & Block LLP s Government Contracts practice group in Washington, D.C. Damien C. Specht is Special Counsel and Co-Chair of the firm s Government Contracts Corporate Transactions practice group. The authors gratefully acknowledge the invaluable assistance of associate James A. Tucker and law clerk Rachael K. Plymale in Jenner & Block s Government Contracts practice group. NO. 14-9 AUGUST 2014 THOMSON REUTERS COPYRIGHT 2014 ALL RIGHTS RESERVED 4-148-337-5

terminations, and risk penalties and fines worth more than the acquired contracts themselves. Starting with the letter of intent and continuing through diligence and continuation of current contracts post-acquisition, this Briefing Paper discusses the special considerations involved in small business Government contracts transactions along with best practices for managing them. Avoiding Affiliation In The Letter Of Intent A concern s status as a small business is one of its most important and valuable assets. This status provides the business with the opportunity to win limited competition set-aside contracts that, under circumstances discussed below, can continue to be performed after the business is acquired by a large business. 3 As a result, it is in both the buyer s and seller s interests to delay the transition to large business status as long as possible. A misstep at the very first stage of the acquisition process the letter of intent can put these interests at risk. The Small Business Administration (SBA) is the federal agency charged with determining size status. The SBA determines the size of a business by reviewing its employee count or revenue along with those of the firm s affiliates. 4 Although this sounds straightforward, the inclusion of affiliates in a size determination poses difficult issues because the SBA will consider far more than a parent, subsidiary, or sister corporation to be an affiliate. Specifically, the SBA will find two entities to be affiliated if one has the power to control the other through ownership, management, or contractual relationships. 5 For example, two concerns may be affiliated if they are owned by immediate family members, share controlling board members, or if one is economically dependent on the other. 6 As a result, if an agreement gives an entity the power to control a small business, even if the two are not in the same corporate hierarchy, the two entities will be said to be affiliated and their employee count or revenues will be calculated in the aggregate. This rule has a clear-cut application when a small business is acquired by a large business; a closed transaction will result in the two firms being in the same corporate chain. At that point, SBA regulations require that a small business recertify its size status and, if the combined entity does not meet the applicable small business size standard, it will no longer be eligible for new set-aside awards. 7 In most cases, however, the purchase agreement is not the first document executed by the parties. Instead, a letter of intent or LOI is used to memorialize key provisions of a transaction before due diligence is completed. LOIs generally include nondisclosure provisions, covenants to negotiate in good faith, and exclusivity restrictions to preclude the target from negotiating with other potential buyers for a certain period of time. LOIs also typically include price terms that, while subject to negotiation, set the baseline for negotiations. Because they are only the springboard for negotiations, LOIs also often contain express provisions indicating that they are nonbinding. Provisions expressly stating that an LOI is nonbinding will not, however, prevent the SBA from finding the buyer and seller to be affiliated. This is the case because the SBA regulations BRIEFING PAPERS This publication was created to provide you with accurate and authoritative information concerning the subject matter covered; however, this publication was not necessarily prepared by persons licensed to practice law in a particular jurisdiction. The publisher is not engaged in rendering legal or other professional advice, and this publication is not a substitute for the advice of an attorney. If you require legal or other expert advice, you should seek the services of a competent attorney or other professional. Briefing Papers (ISSN 0007-0025) is published monthly except January (two issues) and copyrighted 2014 Valerie L. Gross, Editor Periodicals postage paid at St. Paul, MN Published by Thomson Reuters / 610 Opperman Drive, P.O. Box 64526 / St. Paul, MN 55164-0526 http://www. legalsolutions.thomsonreuters.com Customer Service: (800) 328-4880 Postmaster: Send address changes to Briefing Papers / PO Box 64526 / St. Paul, MN 55164-0526 Briefing Papers is a registered trademark used herein under license. All rights reserved. Reproduction, storage in a retrieval system, or transmission of this publication or any portion of it in any form or by any means, electronic, mechanical, photocopy, xerography, facsimile, recording or otherwise, without the written permission of Thomson Reuters is prohibited. For authorization to photocopy, please contact the Copyright Clearance Center at 222 Rosewood Drive, Danvers, MA 01923, (978)750-8400; fax (978)646-8600 or West s Copyright Services at 610 Opperman Drive, Eagan, MN 55123, fax (651)687-7551. 2

treat agreements in principle as having been concluded, even if the purchase agreement has not been signed. 8 In theory, these regulations contain a safe harbor for LOIs because [a]greements to open or continue negotiations towards the possibility of a merger or a sale of stock at some later date are not considered agreements in principle and are thus not given present effect. 9 The SBA s Office of Hearings and Appeals (OHA), 10 however, has found that a sufficiently definite LOI can be an agreement in principle, such that, for size purposes, the deal has already been finalized. 11 Under this rule, businesses can be found to be affiliated despite the fact that negotiations remain open and due diligence must still be completed. If this is the case, the target small business may be ineligible to compete for small business set-aside contracts. To put this risk in context, consider how such a finding would affect a small business competing for a large set-aside contract. This is a valuable opportunity: the seller may increase its revenues, and thus its sale price, while the buyer can acquire a more robust contract pipeline. If the small business signed an LOI that is considered to be an agreement in principle before submitting its proposal for the competition, though, it could be ineligible to compete for that contract. Worse still, if the buyer projected revenue based on award of this program, an affiliation finding based on an LOI, which assumes the deal is allbut-guaranteed, could in fact scuttle the entire transaction. The SBA s regulations provide little bright-line guidance as to when an LOI is an agreement to negotiate and when it is an agreement in principle, but the issue has been addressed in several OHA decisions. In Size Appeal of WRS Infrastructure & Environment, Inc., the OHA found that an LOI created affiliation between the buyer and seller because it included key terms of the potential purchase agreement including price, affirmative language that the acquisition would be executed, and an exclusivity clause. 12 Combined, the OHA found that these terms created an agreement in principle. Although it is not clear why events following execution of the LOI should be part of the analysis, the OHA also found it relevant that the LOI s terms were found in the final stock purchase agreement executed just two months later. The OHA s decision was affirmed by the U.S. Court of Federal Claims, which further added that the LOI clearly established that negotiations and at least some due diligence had already been performed: 13 In reviewing the LOI in this case, it is clear to the Court that on its face the LOI indicates that substantial negotiations had already been held, that partial due diligence had already been performed between buyer and seller, and that WRS intended to purchase [the small business]. The Court agrees that the LOI is an agreement in principle as it was reached after negotiations and due diligence, and represented an agreement to merge as well as providing specific price terms and conditions that were to be included in the closing documents. Further, the Court expressly found that, given the other contents of the document, language expressly stating the LOI was nonbinding was insufficient to avoid a finding of affiliation. 14 In contrast, the OHA has rejected claims that an LOI creates affiliation in a number of cases. For example, in Size Appeal of Kadix Systems, LLC, the OHA rejected the argument that an LOI is an agreement in principle because of its length and complexity, reasoning that [m]any business transactions are finalized only after long negotiation over many points. 15 Similarly, the OHA has found that the mere fact that negotiations have taken place is not sufficient, on its own, to find affiliation based on an LOI. 16 Moreover, even where complex agreements have been drafted or proposed after negotiations occurred, no affiliation exists where there is no tangible evidence that the seller has accepted the buyer s offer. In Size Appeal of Nuclear Fuel Services, Inc., the OHA found an agreement in principle did not exist where the target entity did not sign or accept the agreement, which was merely a tentative proposal to acquire and repeatedly stated that it was nonbinding. 17 The OHA s factual analysis in Size Appeal of W.I.N.N. Group also helps set the boundaries for avoiding affiliation based on an LOI: 18 The offer describes itself as non-binding. The letter does not include a set price, but a rather a range between $[xxx] and $[xxx]. The letter carefully conditions the non-binding offer on further due diligence by [Buyer]. [Buyer] requires 3

extensive additional information from [Seller] as part of its due diligence, including all contractual instruments, third party and Government audit reports (including those from the Defense Contract Management Agency), rosters of employees and contractors, balance sheets and a documentation of all assets, including real property and leases. The letter anticipates that a confirmatory offer would be made once the due diligence is completed. In that case, the OHA further noted that not only was the price range in the LOI too wide to be considered a binding agreement, but also that the parties were free to withdraw from the agreement at any time. 19 In sum, small business Government contractor LOIs must be carefully drafted, keeping in mind that there are no bright-line rules in this area. Buyers and sellers should also remember that the SBA will consider all of the terms of an LOI in its analysis, so simply because a term was found acceptable in one context does not mean that same term, in conjunction with others, will not result in a finding of affiliation. Based on available case law, small business contractors and buyers should avoid including the following in LOIs: (1) Exact price terms, although sufficiently wide price ranges may be acceptable; (2) Executing an LOI too close in time to the final agreement; (3) Exclusivity clauses; and (4) Affirmative statements that the parties intend to execute an agreement based on the LOI s terms. To help increase the chances that an LOI will not create affiliation, drafters should consider: (a) Multiple, express statements of the conditional and nonbinding nature of the agreement; (b) Language providing for future negotiations between the parties; (c) Provisions conditioning the LOI on a future, more definite offer; and (d) Contingencies on due diligence and the provision of information by the seller. Small Business Diligence Once the parties have agreed to an appropriate LOI, full-scale diligence can begin. In addition to the compliance issues inherent in all Government contractor transactions, specific regulations applicable to small business set-aside contracts require additional scrutiny. This diligence is especially important after the Small Business Jobs Act of 2010 established harsh penalties for misrepresentations of small business size status up to relinquishment of the entire contract price. 20 Buyers and sellers alike must be diligent in assuring compliance with SBA regulations to avoid liabilities that may potentially exceed the value of the contracts themselves by a significant amount. Identifying Set-Asides The first challenge in small business diligence is identifying contracts that implicate small business regulations, including small business setaside contracts and contracts awarded using a socioeconomic pricing preference. As discussed below, the set-aside status of contracts will determine their value, ability to transition to a buyer, and transfer procedures. Just because award is made to a small business, however, does not mean the contract is a small business set-aside that implicates these special requirements. In general, contracts will indicate set-aside status on the cover page. For example, contracts using the Standard Form 1449, Solicitation/Contract/ Order for Commercial Items, should indicate in Block 10 whether that contract is unrestricted or a set-aside, and if so, what percentage is set-aside for what type of small business. 21 Review of possible setaside contracts cannot end at the first page because, in many instances, the front page of the contract contains incomplete or misleading information. If the front page of the contract is inconclusive or there is reason to believe that it is incorrect, a review of the clauses included in the contract is necessary. Inclusion of the following clauses is evidence that the contract is a set-aside or partial set-aside: (1) FAR 52.219-6, Notice of Total Small Business Set-Aside ; 4

(2) FAR 52.219-7, Notice of a Partial Small Business Set-Aside ; (3) FAR 52.219-17, Section 8(a) Award ; (4) FAR 52.219-27, Notice of Service-Disabled Veteran-Owned Small Business Set-Aside ; (5) FAR 52.219-29, Notice of Set-Aside for Economically Disadvantaged Women- Owned Small Business Concerns ; (6) FAR 52.219-30, Notice of Set-Aside for Women-Owned Small Business- Concerns Eligible Under the Women-Owned Small Business Program ; and (7) FAR 52.219-3, Notice of Total HUBZone Set-Aside or Sole Source Award. 22 If even one of these clauses is present in a contract, that is strong evidence that the contract was awarded on a set-aside basis. If these clauses conflict with other contract documentation, a savvy buyer should request the relevant solicitation to identify whether a contract was competed on a set-aside basis. Evaluating Manufacturing Contract Compliance If small business set-aside supply contracts are identified, buyers should ensure that they assess the seller s compliance with the SBA s regulations regarding manufacturing. Specifically, the awardee of a set-aside supply contract must provide products that it manufactures itself. 23 For these purposes, [t]he manufacturer is the concern which, with its own facilities, performs the primary activities in transforming inorganic or organic substances, including the assembly of parts and components, into the end item being acquired. 24 This does not mean that the small business must provide all the components of the end item. 25 Instead, it must perform more than minimal operations upon the end item. 26 As the OHA has explained, the minimal activities that will not meet this test are merely unpacking, modifying, on-site assembly, installing, and integrating components. 27 In evaluating whether operations are minimal, the SBA will consider (a) the proportion of total value in the end item added by the efforts of the concern, (b) the importance of the elements added by the concern to the function of the end item, regardless of relative value, and (c) the concern s technical capabilities, facilities and equipment, production or assembly line processes, labeling of products, and product warranties. 28 The SBA s regulations provide a small exception to this rule for small business product distributors so long as they (1) do not have more than 500 employees, (2) are primarily engaged in the retail or wholesale trade, (3) normally sell the type of item being supplied, (4) take ownership or possession of the item(s) with their personnel, equipment, or facilities in a manner consistent with industry practice, 29 and (5) supply goods made by a U.S. small business. 30 The OHA has confirmed that an entity must meet all five prongs of this test to fit within this nonmanufacturer rule exception. 31 Many small businesses are not aware of these rules, however, and even if they are, may not have the internal controls in place to comply. Fortunately, because these rules are well defined, determining compliance as part of a small business transaction requires only a few targeted questions: (a) Does the small business perform more than minimal operations with its own personnel and equipment upon the items it delivers under its supply contracts? (b) Does it have the facilities and expertise to support those operations? (c) If not, does the business meet the five-part nonmanufacturer rule test? Notably, negative responses from a small business may not, alone, indicate noncompliance. The SBA may issue waivers allowing small businesses to provide goods produced by large businesses if the contracting officer has determined that no small business manufacturer or processor reasonably can be expected to offer a product meeting the specifications and SBA reviews and accepts that determination or if the SBA determines that no small business manufacturer or processor of the product or class of products is available to 5

participate in the Federal procurement market. 32 Thus, negative responses to these questions will require additional diligence. Evaluating Services Contract Compliance Services contracts that have been set aside for small businesses have their own limitations that must also considered in a mergers and acquisitions transaction. Specifically, the SBA requires that 50% of the cost of a small business set-aside contract be performed by that firm s own employees. 33 Importantly, limitations on subcontracting do not apply to contracts awarded to small businesses through unrestricted competitions (unless the awardee is a historically underutilized business zone (HUBZone) business that benefited from that program s price preference). 34 Assessing compliance with this rule in the process of contract diligence is challenging as many businesses lack the ability to track subcontracting percentages in real-time. As a result, this issue should be raised with a small business seller to determine familiarity with the requirements, but compliance is best addressed through diligence coupled with protective purchase agreement terms. Another nuance in this rule that buyers should consider is related to multiple award contracts. Under total or partial set-aside multiple award contracts, subcontracting percentages are based on the base period and then, separately, each option period. 35 This allows small businesses to perform task orders under which they would violate limitations (by subcontracting over 50% of the work) so long as the aggregate of all work subcontracted over the period of the contract does not exceed 50% of the cost of the contract. 36 The language of each contract and task order should be read carefully, however, as Contracting Officers (COs) have the discretion to require contractors to comply with limitations on subcontracting for each individual order. 37 The National Defense Authorization Act for Fiscal Year 2013 (2013 NDAA) modified the compliance measurement for limitations on subcontracting, but at the time of this writing, the modification has not yet been implemented in the regulations. 38 Previously, subcontracting percentages were calculated based on the cost of work performed by employees, requiring contractors to separate out costs for personnel. The 2013 NDAA revised the calculation method from personnel costs to total contract price. 39 Although this change may ultimately reduce the amount of work that can be subcontracted, as nonlabor costs such as materials and supplies are no longer excluded from subcontracting calculations, it significantly reduces the burden of determining compliance for small contractors and potential acquirers. It is worth noting that some small business programs have their own subcontracting rules. For example, diligence related to contracts set aside under the 8(a) program for small disadvantaged businesses should consider the fact that special waivers of limitations on subcontracting may be available from the SBA. 40 In addition, buyers of 8(a) firms can take some comfort in the fact that the SBA performs semiannual audits to insure that these contractors perform certain percentages of work with [their] own employees. 41 Further, although most subcontracting limitations apply only to set-aside contracts, diligence of HUBZone contractors must go a step further. This is the case because HUBZone contractors must perform 50% of any contract under which they received a HUBZone price preference. 42 If a HUBZone chooses to waive its price preference for a full and open contract award, however, it is not subject to limitations on subcontracting. 43 Although small business subcontracting limitations are often overlooked in diligence, the consequences for noncompliance are significant. After the passage of the 2013 NDAA, a small business that does not meet the subcontracting limitations may be subject to penalties equaling the dollar amount expended, in excess of permitted levels, by the entity on subcontractors. 44 Coupled with the False Claims Act s potential for treble damages, these penalties may create serious liability that must be identified as early as possible in diligence so that appropriate purchase agreement terms can be drafted. Given the nuance of small business service contract subcontracting rules, diligence in this 6

area is challenging. A review of key subcontracts and teaming agreements can help identify concern areas if it becomes apparent that a large subcontractor is guaranteed workshare beyond 50%. In addition, general questioning of small business contract personnel can help gauge understanding and compliance with these rules. If these strategies do not result in a conclusion as to compliance, this issue can be addressed through a specific representation in the purchase agreement. Assessing The Value Of Current Set-Asides Long-term contracts are one of the most valuable assets of a small-business seller. Not all of these contracts have value to a large business buyer, however. In general, size is determined before award of a set-aside contract. 45 As a result, a small business can continue to perform a set-aside contract even if it grows to be other than small. If a small business concern is acquired by or acquires another concern, however, this baseline rule does not apply and the business must recertify its size. 46 Notably, the Government is not required to terminate the contract based on a recertification as other than small. Instead, it can continue to place orders and exercise options. That said, the Government can no longer claim small business credit for these orders and options. 47 Not all transfer rules are this straightforward. Socioeconomic Program Transfer Rules In addition to the baseline rule that small business set-aside contracts can continue to be performed by a large acquirer, each of the myriad other small business socioeconomic programs has its own unique transfer rules. The most restrictive transfer rules apply to the 8(a) program for businesses owned by individuals that are socially and economically disadvantaged. 48 Contracts governed by the 8(a) program must be performed by the participant that received the award unless a waiver is granted. 49 To maintain compliance with this rule, 8(a) participants must notify SBA in writing immediately upon entering into an agreement or agreement in principle (either oral or written) to transfer all or part of its stock or other ownership interest or assets to any other party. 50 As the regulations explain, [s]uch an agreement could include an oral agreement to enter into a transaction to transfer interests in the future. 51 If ownership of an 8(a) concern changes or the contract is transferred or novated for any reason, the contract must be terminated for the convenience of the Government unless a waiver is granted by the SBA Administrator. 52 Waivers are based on the justification that termination of the contract would severely impair attainment of the agency s program objectives or missions. 53 As a result, unless a program is nearing completion or the work is highly differentiated, a buyer should not expect to receive a waiver to continue performance of existing 8(a) contracts. Because 8(a) contracts are difficult to transfer, program participants considering a sale should think strategically about ways to maintain this work. For example, 8(a) participants can identify an early-stage 8(a) firm and join with that firm in the SBA 8(a) mentor-protégé program. This program, which may expand in coming years, 54 allows contractors of any size to participate in 8(a) set-aside competitions with an 8(a) protégé. 55 The mentor, regardless of its size, can perform up to 60% of a contract awarded to the resulting mentor-protégé joint venture. 56 Because this 60% share is not tied to the size of the mentor, this program may provide a strategy for an 8(a) concern to maintain a significant portion of its work through a transaction. Contracts awarded under the other socioeconomic preference programs also have their own transfer rules. Generally, if a business is acquired by a person or entity that is not eligible to participate in the socioeconomic program the contract was awarded under, the contractor may continue to perform the contract but any options and task orders awarded may not be counted by the agency toward its program goals. 57 If, however, a transaction involves a similarly situated owner, it may be possible for performance to continue while the Government continues to claim socioeconomic credit. For example, the Government may continue to claim 7

credit for a service- disabled veteran-owned setaside contract if one or more service-disabled veterans own and control [the business] after the change. 58 Changes of ownership between eligible veterans, however, must be supported by a new program application. If the buyer is not a service-disabled veteran, the rules for standard small business set-asides apply and performance may continue without the Government claiming socioeconomic credit. 59 For HUBZone concerns, a change in ownership or business structure is considered a material change and must be reported to the SBA in writing for a reevaluation of certification eligibility. 60 If the acquirer is not eligible for the HUBZone preference, the firm may continue to perform HUBZone contracts after a transaction, but the agency may no longer count any options or orders issued towards its socioeconomic goals. 61 As these regulations demonstrate, conventional wisdom that small business contracts have little to no value in an merger or acquisition is incorrect. In most circumstances, incumbent work can transfer to a buyer, regardless of its size. Many buyers have discovered, however, that the loss of size status makes it difficult to retain work after the initial period of performance has expired. In addition, some buyers have found incumbent contracts recompeted early to allow the Government the opportunity to regain small business credit. As a result, customer familiarity and differentiation of the contractor s products and services must be considered in conjunction with the SBA s transfer rules to assess the value of a firm s contract portfolio. Multiple Award Contracts In recent years, the Government has acquired an increasing amount of services and supplies through indefinite-delivery, indefinite-quantity (IDIQ) contracts. These contracts often have multiple awardees and, because they involve future task or delivery order competitions, pose an additional challenge for small business transactions. A change in size status as a result of an acquisition does not necessarily require that a set-aside IDIQ contract be terminated or that options cannot be exercised. 62 However, some of these contracts contain off ramp clauses requiring that any business that becomes other-than-small as a result of a merger or acquisition will become ineligible for future awards. 63 Other multiple awardee contracts may state that while a concern will no longer be eligible for future orders set aside for small businesses, the concern will be allowed to graduate to compete for orders among the large contract awardees. Such a clause was used in the Department of Homeland Security s first Enterprise Acquisition Gateway for Leading Edge Solutions (EAGLE I) IDIQ program. The now expired EAGLE I contract provided that if a small business set-aside contract holder was acquired, the contractor would no longer eligible to compete under a set-aside requirement as of the effective date of the modification (reflecting the contractor s new size status), but that the contractor would continue to be eligible to compete on future unrestricted requirements until the expiration of the five-year base period. Because of this provision in multiple awardee IDIQ contracts, a large business that is shut out of a multiple award contract may be able to gain access to that vehicle through acquisition of a small business contract holder. In all events, an acquiring concern must look for these off ramps and graduation provisions in its due diligence of a small business concern s contracts because the treatment of these contracts will not be dictated by the SBA s regulations alone. In addition, if a small business concern has an off-ramp clause in a long-standing contract, it may be worth broaching the subject with the CO to see if the agency would be amenable to modifying the contract to allow for continued performance or graduation to the large business competition. The text of the contract does not complete the required diligence. Even if a large business can continue to hold a multiple award IDIQ contract, a CO may set aside and require size recertification for specific task or delivery orders. 64 If recertification is requested for a set-aside order, any small business concern that has become other-than-small as a result 8

of a merger or acquisition will lose the ability to compete for that order. It is imperative, therefore, for buyers to both be familiar with the relevant regulations and closely scrutinize the seller s multiple award contracts. This diligence should include an assessment of how many small business offerors remain and the history of whether size certifications have been requested for past task orders. Failure to do so may leave buyers with an IDIQ contract under which they cannot receive future orders. The Purchase Agreement In addition to reflecting any issues discovered during diligence, purchase agreements for small business contractors should address the significant liability that can result from an inaccurate small business certification. These representations should include a specific schedule requiring a complete list of set-aside contracts such as the following: Except as set forth in Section [ ] of the Disclosure Schedule, no Government Contract or Government Contract Bid is based on the Company having status as a small business, small disadvantaged business, service-disabled veteran-owned small business, woman-owned small business, participant in the SBA s 8(a) Business Development program, protégé, or other preferential status afforded by statute or regulation, nor did the Company certify, or represent to a Governmental Authority, as qualifying for such set-asides. This schedule will provide a basis for determining whether the contracts at issue can transfer and what future revenue the buyer can expect from the seller s current contracts. Moreover, requiring the seller to provide this schedule will confirm that all required contract documents have been provided. Although many purchase agreements include general representations related to compliance with the terms of current contracts and applicable law that address a failure to meet small business subcontracting limitations, parties should also consider a specific representation related to the certifications that led to a seller s contracts. An example of such a representation is: All facts set forth in or acknowledged by any representations, certifications, or disclosure statements made or submitted by or on behalf of the Company in connection with each of the Government Contracts and each of the Company s quotations, bids, and proposals for Government Contracts were current, accurate, and complete in all material respects as of the date of submission. In addition to prime contracts, size may be relevant to some of the subcontracts under which the seller is performing. If the seller s higher tier contractor can no longer claim small business credit after a transaction, it may reduce the amount of work provided under the subcontract or may terminate the agreement altogether. Although it is difficult to predict those actions, inclusion of a representation similar to the following provides some protection for the buyer from a sudden drop off in subcontract revenue as a result of size status: No customer has indicated an intention to cease purchasing products or services from the Company (or materially decrease the amount of such purchases) after the Closing as a result of the Company s loss of status as small business or similar preferential status category. Because it may difficult for the seller to have knowledge of a customer s intentions, many buyers also use third-party services or specifically worded scripts to address the issue of a reduction in work from loss of size status with customers during diligence. Finally, when negotiating purchase agreements involving small businesses, buyers should also keep in mind that potential damages under the False Claims Act for a false representation of size status may exceed total contract value for set-aside contracts. As a result, if the buyer has specific concerns about given contracts, a special indemnity may be required that is removed from the general liability cap. Of course, a special indemnity would likely be an inadequate remedy for potential suspension or debarment that can also result from inaccurate size representations. Minority Investment Issues Although the majority of this Briefing Paper has addressed acquisition of small business 9

contractors, minority investments in small businesses also present unique issues for investors and small businesses. Under current SBA regulations, certain minority investments may support a finding of affiliation between the small business concern and the investor, jeopardizing the concern s status as a small business and its ability to compete for setaside contracts. Minority investment will result in a finding of affiliation between the investor and a small business concern when an investor entity controls a block of voting stock which is large compared to other outstanding blocks of voting stock. 65 There is no black letter rule as to when a minority block of stock is large compared to other outstanding blocks, but the OHA has found control to reside in holders of as little as 17% of a small business concern a far smaller amount than many investors would anticipate. 66 As a result, minority investors and potential investors should not rely on the fact that they will hold less than 50%, or even less than 20%, of a concern to conclude that the firm can continue to compete for set-aside contracts. Further, it is not a defense to an affiliation claim that an investor holds a comparable amount of stock to, for example, the small business founder s block. When two or more comparable minority owners have holdings that are large compared with any other stock holding, the SBA will presume that both control the entity. 67 Even if they do not control a large block of stock relative to other stockholders, minority investors often insist on certain controls, or negative covenants, to protect their investment. Typical negative covenants include consent to incur significant debt, pay dividends, issue additional stock, or amend the concern s charter. These negative controls can, however, create affiliation that can cost the ability to compete for set-aside work. Even a small minority holder can be found to control if they have negative covenants beyond those required to protect their investment. As a general rule, the OHA has found the following common negative covenants to contribute to a finding of affiliation: incurring more than a day-to-day amount of debt, payment of dividends, forming a quorum of shareholders, and determining employee compensation. 68 Minority shareholders may retain the power to veto unusual or extraordinary actions that are designed to protect the interests of the minority investor without resulting in affiliation. Acceptable negative control includes the power to veto issuance of additional stock, amendment of concern s charter or bylaws, entry into substantially different lines of businesses, adding new members to a limited liability company, and dissolution of the company. 69 Post-Acquisition Issues Maintaining the value of contracts purchased is a key part of a small business transaction. Given the issues surrounding transfer of small business multiple award IDIQ contracts, discussed above, it is not surprising that many firms are facing size protests of task orders awarded after a sale. Many of these challenges are, however, untimely and fail to recognize the OHA s strict rules regarding size certification. For long-term contracts such as multiple-award contracts, size protests are only timely at three points: (1) when the base contract is initially awarded, 70 (2) when option years in the base contract are exercised, 71 and (3) when size certification is expressly requested in connection with an individual order. 72 The key for Government contracts mergers and acquisitions lawyers is to recognize two categories that do not provide for a timely protest. First, recertification as a result of a merger or acquisition does not support a timely protest. The OHA has held that the SBA will not entertain a size protest against the award of an order under a [Government-wide acquisition contract] or other long term contract, unless the procuring agency requested recertification in conjunction with that order. 73 As a result, unless recertification is required for a specific task order, a size protest of a task order based on a recertification will be untimely. 74 10

Second, simply setting aside a task order for small business does not support a timely size protest. A CO s request for recertification must be clear to create grounds for a protest. The OHA has explained that merely setting aside a task order for small business does not create an implied certification that would support a size protest. 75 In sum, buyers should expect size protests under multiple award contracts. If the buyer has provided all required notices to the Government and recertification has not been required for the task order that is the subject of the protest, however, there are a number of defenses available to maintain such an award. Conclusion Because a large percentage of mergers and acquisitions in the Government contracts space involve small businesses, investors and business owners must be aware of the special risks and unique pitfalls involved in these transactions. Failure to use the correct language, perform the required diligence or understand nuanced transfer rules can harm both the buyer and the seller. From the letter of intent, through diligence, the purchase agreement, and any resulting size protest, Government contracts attorneys cannot forget the nuances related to small business transfers. These Guidelines are intended to assist you in understanding the key issues involved in mergers and acquisitions involving small business Government contractors and the best practices for managing them. They are not, however, a substitute for professional representation in any specific situation. 1. When drafting the LOI for a small business transaction, avoid the appearance of certainty on price and diligence terms. Even if no agreement in principle has been reached, the SBA will base its decision on this document in a potential size challenge. 2. In contract diligence, look past the cover page of the contract to the referenced clauses. These will provide an indication whether the contract was awarded to a small business on the basis of full and open competition or if it is a set-aside contract. 3. For set-aside supply contracts, focus diligence on the entity that transforms the components into the end item being acquired, not necessarily the value of the components or their source. 4. Be aware that small businesses that are not the manufacturers of supplies provided under set-aside contracts are not necessarily noncompliant as the nonmanufacturer rule and various waivers may apply. 5. For set-aside service contracts, ensure that diligence includes an evaluation of whether the small business is performing 50% or more of the cost of services with its own personnel. This is challenging for IDIQ contracts, where the GUIDELINES requirement may be applied on a task order or contract year basis. 6. Remember that generally, small business set-aside contracts can transfer to a large business. However, the Government can no longer claim small business credit, which may lead to early recompetition of requirements. 7. Keep in mind that contracts awarded under the 8(a) program, however, must be terminated at transfer unless a waiver is granted. As a result, 8(a) contract holders should consider participation in the SBA 8(a) mentor-protégé program. 8. Bear in mind that multiple award contracts may include tailored provisions that restrict transfer or limit the ability of a large business buyer to compete for task orders. In addition, specific recertification requests for task order competitions may render large concerns ineligible to bid. Take special care to review past task order solicitations and contract clauses. 9. Given the significant liability related to misrepresentation of size status, ensure that purchase agreements include provisions related to the accuracy of representations and provided for indemnity. 10. Be aware that minority investors in small business Government contractors are not immune from affiliation. Investors should pay particular attention to the size of their holdings relative to other minority interests and should take care not to impose negative covenants that limit the concern s day-to-day operations. 11

REFERENCES 1/ See generally Dover, Horan & Overman, Mergers & Acquisitions Special Considerations When Purchasing Government Contractor Entities/Edition II, Briefing Papers, No. 09-7 (June 2009). 12/ Size Appeal of WRS Infrastructure & Env t, Inc., SBA No. SIZ-5007 (2008). 13/ WRS Infrastructure & Env t, Inc. v. United States, 85 Fed. Cl. 442, 445 (2009). 2/ See generally Cairnie & Kessler, Organizational Conflicts of Interest/Edition V, Briefing Papers No. 12-13 (Dec. 2012). 14/ 85 Fed. Cl. at 446. 3/ See generally Hewitt, Small Business Contracting Programs: An Update, Briefing Papers No. 12-8 (July 2012); Hewitt, Williams & Alba, Small Business Contracting Programs Part I, Briefing Papers No. 10-11 (Oct. 2010); Hewitt, Williams & Alba, Small Business Contracting Programs Part II, Briefing Papers No. 10-13 (Dec. 2010). 15/ Size Appeal of Kadix Sys., LLC, SBA No. SIZ-5016 (2008). 16/ See Size Appeal of Tech. Sys. Assocs., Inc., SBA No. 3963 (1994) (present effect rule does not apply where there is no evidence of a formal agreement even where some negotiations have occurred). 4/ 13 C.F.R. 121.103(a)(6). 5/ 13 C.F.R. 121.103(a)(1) (2). 17/ Size Appeal of Nuclear Fuel Servs., Inc., SBA No. SIZ-5324 (2012). 6/ See 13 C.F.R. 121.103(f) ( Affiliation based on identity of interest ); see also 13 C.F.R. 121.103(e) ( Affiliation based on common management ). 18/ Size Appeal of W.I.N.N. Group, Inc., SBA No. SIZ-5360 (2012). 19/ Size Appeal of W.I.N.N. Group, Inc., SBA No. SIZ-5360 (2012). 7/ 13 C.F.R. 121.404(g). 8/ 13 C.F.R. 121.103(d)(1). 9/ 13 C.F.R. 121.103(d)(2). 10/ See 13 C.F.R. 134.102. 11/ See Size Appeal of WRS Infrastructure & Env t, Inc., SBA No. SIZ-5007 (2008) (parties to the LOI were affiliated when the LOI was executed despite its titling as a Non-binding Agreement and the inclusion of express provisions making the nonbinding nature of the LOI clear). 20/ The Small Business Jobs Act of 2010, Pub. L. No. 111-240, 1341, 124 Stat. 2504, 2543 (2010) (adding 15 U.S.C.A. 632(w)) created the so-called presumed loss rule for size status misrepresentation. Although misrepresentation of size status has always carried sanctions, the Small Business Jobs Act allows the Government to claim harm in the amount of the entire value of the contract(s) at issue when a contractor willfully misrepresents its size. In conjunction with the treble damages under the False Claims Act, 31 U.S.C.A. 3729 3733, the presumption creates the potential for penalties that are far beyond the total value of a firm s contracts. To illustrate, if a contractor received a $10 million set-aside contract by misrepresenting that it was a small business, under the presumed loss rule, the Government s damages would be $10 million. If the Government pursued 12

fraud claims under the False Claims Act for the misrepresentation, the small business could face a judgment of $30 million plus penalties. 21/ A sample of the Standard Form 1449 can be found at http://www.gsa.gov/portal/ forms/download/115922. 30/ 13 C.F.R. 121.406(b)(1). Small businesses may also assemble and deliver kits composed of items manufactured by other entities so long as the small business does not exceed 500 employees and 50 percent of the total value of the components of the kit [is] manufactured by business concerns in the United States which are small under the size standards for the NAICS codes of the components being assembled. 13 C.F.R. 121.406(c). 22/ If the target is a HUBZone certified contractor, the clause at FAR 52.219-4, Notice of Price Evaluation Preference for HUBZone Small Business Concerns, is also important as it triggers similar subcontracting limitations that should be reviewed during the due diligence process. 23/ 13 C.F.R. 121.406(a)(1). 24/ 13 C.F.R. 121.406(b)(2). 25/ 13 C.F.R. 121.406(b)(2). 31/ See Size Appeal of Ira Green, Inc., SBA No. SIZ-5287 (2011) (size determination remanded to Area Office to investigate whether all five requirements of the nonmanufacturer rule applied). 32/ 13 C.F.R. 121.406(b)(5). Waivers can be requested on a class or individual procurement basis. Class waivers apply to all items in a class or category for all procurements and are applicable until revoked by the SBA. Both the Government and contractors can request class waivers. Individual waivers apply only to one solicitation or line items within a solicitation. These waivers must be applied for by the CO to the SBA Administrator or a designated representative and must be supported by market research finding no eligible small business manufacturers. See 13 C.F.R. 121.1204. 26/ 13 C.F.R. 121.406(b)(2). 27/ See Size Appeal of Am. Sys. Corp., SBA No. 4022 (1995). 28/ 13 C.F.R. 121.406(b)(2)(i); see Size Appeal of Fernandez Enters., LLC, SBA No. SIZ-4863 (2007). 33/ 13 C.F.R. 125.6(a)(1). For general construction contracts, (typically North American Industry Classification System (NAICS) codes beginning with 236 and 237), the awardee must perform at least 15% of the cost of the contract (excluding materials) with its own employees and 25% for construction by special trade contractors (typically NAICS codes beginning with 238). 13 C.F.R. 125.6(a)(3) (4). 34/ 13 C.F.R. 125.6(f). 29/ The SBA has clarified that the requirement to take ownership or possession of the goods or services supplied to the Government is a safeguard against abuses by small businesses simply acting as pass-through entities for large businesses when a waiver is in place. 76 Fed. Reg. 8222, 8225 26 (Feb. 11, 2011). The rule requires that small business contractors contribute more to the procurement than simply their status as a small business. 76 Fed. Reg. at 8226. This does not prevent the regular commercial practice of drop-shipping as long as the shipper is a small business. Size Appeal of Wear Mark, Inc., SBA No. SIZ-5397 (2012). 35/ 13 C.F.R. 125.6(f); see also 78 Fed. Reg. 61114, 61126 (Oct. 2, 2013). 36/ 13 C.F.R. 125.6(f); see also 78 Fed. Reg. at 61126. 37/ 13 C.F.R. 125.6(f); see also 78 Fed. Reg. at 61126. 13

38/ National Defense Authorization Act for Fiscal Year 2013, Pub. L. No. 112-239, 1651, 126 Stat. 1632, 2079 (2013) (amending 15 U.S.C.A. 657s). 48/ See generally 13 C.F.R. 124.1 et seq. 49/ 13 C.F.R. 124.515(a). 39/ Pub. L. No. 112-239, 1651. 50/ 13 C.F.R. 124.515(g). 40/ 13 C.F.R. 124.510(c)(4). 51/ 13 C.F.R. 124.515(g). 41/ 13 C.F.R. 124.112(b)(8) (The SBA s annual reviews of 8(a) participants includes a review of whether subcontracting requirements are being met.); see 13 C.F.R. 124.510. 52/ 13 C.F.R. 124.515(a). 42/ See FAR 52.219-4(d) ( A HUBZone small business concern agrees that in the performance of the contract, in the case of a contract for (1) Services (except construction), at least 50 percent of the cost of personnel for contract performance will be spent for employees of the concern or employees of other HUBZone small business concerns; (2) Supplies (other than procurement from a nonmanufacturer of such supplies), at least 50 percent of the cost of manufacturing, excluding the cost of materials, will be performed by the concern or other HUBZone small business concerns. ). 53/ 13 C.F.R. 124.515(b)(4). 54/ See Pub. L. No. 112-239, 1641 (amending 15 USCA 657r). The section provides that the SBA may create mentor-protégé programs for all small businesses modeled after the 8(a) program, but nothing in the Act required the SBA to do so. 55/ 13 C.F.R. 124.520(d)(1). 43/ See FAR 52.219-4(c) ( Waiver of evaluation preference. A HUBZone small business concern may elect to waive the evaluation preference, in which case the factor will be added to its offer for evaluation purposes. The agreements in paragraphs (d) and (e) of this clause do not apply if the offeror has waived the evaluation preference. ). 56/ 13 C.F.R. 124.513(d). 57/ See, e.g., the Woman-Owned Small Business Program under 13 C.F.R. 127.503(f) (i). 44/ Pub. L. No. 112-239, 1652 (adding 15 USCA 645(g)). 58/ 13 C.F.R. 125.9(f). 45/ 13 C.F.R. 121.404(a). 59/ 13 C.F.R. 125.15(e)(1)(i). 46/ 13 C.F.R. 121.404(g). 60/ 13 C.F.R. 126.501. 47/ 3 C.F.R. 121.404(g). 61/ 13 C.F.R. 126.601(h)(1)(i). 14

62/ 13 C.F.R. 121.404(g) ( A concern that represents itself as a small business and qualifies as small at the time of its initial offer (or other formal response to a solicitation), which includes price, is considered to be a small business throughout the life of that contract. Where a concern grows to be other than small, the procuring agency may exercise options and still count the award as an award to a small business. ). 63/ See 13 C.F.R. 125.2(e)(2)(iii). The SBA issued a final rulemaking regarding off-ramping in 2013, explaining that if a small business awarded a total or partial set-aside multiple award contract becomes other than small as a result of a merger or acquisition, it is up to the contracting officer to decide whether to terminate, or off-ramp the contractor. However, any awards issued to such a contractor will not count as an award to a small business. 78 Fed. Reg. 61114, 61116 (Oct. 2, 2013). sufficient to support a finding of affiliation); Size Appeal of Carntribe-Clement 8AJV #1, LLC, SBA No. SIZ-5357 (2012) (negative control exists if a minority owner can block ordinary actions essential to operating the company.). 69/ See, e.g., Size Appeal of EA Eng g, Sci. & Tech. Inc., SBA No. SIZ-4973 (2008) (reversing a finding of negative control and holding that requiring supermajority vote to amend the charter or bylaws, issue additional shares of capital stock, and enter into substantially different business served to protect the minority shareholder s investment and did not interfere with the majority owner s operation of the business); Size Appeal of DHS Sys. LLC, SBA No. SIZ-5211 (2011) (requiring unanimous agreement for certain actions including adding or subtracting board members or changing lines of business does not support a finding of control). 64/ See Size Appeal of Quantum Prof. Servs., Inc., SBA No. SIZ-5207 (2011). 70/ 13 C.F.R. 121.1004(a)(3)(i). 65/ 13 C.F.R 121.103(c)(1). 71/ 13 C.F.R. 121.1004(a)(3)(ii). 66/ See Size Appeal of Novalar Pharm., Inc., SBA No. SIZ-4977 (2008) (affiliation existed where a large business owned a minority share of 17% of the business, which was greater than the next largest shareholder at 8%). Although not directly applicable to small business contracts, for purposes of the Small Business Innovation Research (SBIR) program, control sufficient for a finding of affiliation is presumed when minority owners control 40% or more of a participant s voting stock. 13 C.F.R 121.702(c)(1). The SBA has taken this position based on its understanding of the existing OHA case law. 72/ 13 C.F.R. 121.1004(a)(3)(iii); see Size Appeal of Quantum Prof. Servs., Inc., SBA No. SIZ-5207 (2011) (task order size protests for set-aside task orders under contracts awarded using unrestricted competition are only timely if the CO requests express recertification in connection with the specific task order). 73/ Size Appeal of Reliasource, SBA No. SIZ- 5536 (2014). 67/ 13 C.F.R. 121.103(c)(2). 74/ Tyler Constr. Group, Inc., SBA No. SIZ-5323 (2012); Size Appeal of Quantum Prof. Servs., Inc., SBA No. SIZ-5207 (2011). 68/ See, e.g., Size Appeal of DHS Sys. LLC, SBA No. SIZ-5211 (2011) (powers beyond those necessary to protect a minority shareholder s investment, including negative control over the compensation committee, corporate budgets, incentive plans, and choices of accountants and auditors, is 75/ See Size Appeal of Safety & Ecology Corp., SBA No. SIZ-5177 (2010) (inclusion of small business set-aside clauses is not considered an express recertification request). 15

BRIEFING PAPERS