Jerry Grossman | New SBA size further stratifies small business

Market Watch

Arguably, the Small Business Administration's final rule, announced Nov. 15, regarding small-business size recertification under long-term federal contracts has few beneficiaries in the long term, except, perhaps, unsuccessful small businesses.

Government is not better served, taxpayers don't save money, efficiency doesn't increase and quality is not improved. It does not foster the continuing growth of breakout small companies or their employees.

Shareholders of emerging small companies ? and that usually includes many of their employees ? may see fewer professional growth opportunities or diminished company stock value as a by-product of the new rule.

The new rule applies to governmentwide acquisition contracts, General Services Administration multiple-award schedule contracts and multiple-agency contracts that, including options, are for more than five years. The rule also applies to all contracting actions in effect in environments in which an acquisition, merger or novation occurs.

The result will be an increased air of uncertainty surrounding the sale of a small business to, or merger with, a large business. Federal contracting officers, although not prohibited from exercising an option or continuing a contract, post sale or merger, may fail to meet small-business goals unless a new, qualified small business takes over the work.

On balance, for most small federal contractors, this new rule has the potential to cause harm. Particularly vulnerable are those companies that deliver a mix of services that are commonplace or that resemble; that is, in situations in which the customer can find in the market several alternative companies delivering comparable service. Companies in this group are most likely to be net losers as the recertification process goes into effect.

Alternatively, those small businesses that have distinguished attributes such as exceptional technical depth aligned with customer priorities, domain expertise, high-level clearances and strong past performance, will experience a modest, if any, effect.

For some customers, these distinguished businesses may represent the only small company within the small-business universe that has the capabilities to do the job. Accordingly, the contracting officer is likely to retain the contractor beyond its failure to qualify as small.

The ultimate consequences and effects of this rule won't be clear for several years, but many of its effects are predictable. Many successful, fast-growing small businesses may lose contract positions or customer relationships when they cease to be small.

In these circumstances, the historical success of the companies leads to increased uncertainty as they grow beyond the small standard. Strong business relationships, built over the years with government customers, may be outweighed by small-business contract guidelines in an agency. The unpredictability of these outcomes will increase.

In some circumstances, subcontract roles may have more sustainability than prime positions, as subcontract arrangements are not subject to these recertification rules.

The most significant effect of the new rules is likely to be on the merger and acquisition market. In many instances, valuations will be lowered and due diligence processes will be deepened. The imperative for buyers in M&A transactions derives from a combination of opportunity and confidence in the future. Acquirers seek comfort in the belief that the acquired company's customers will remain loyal, the contracts will run their full term and beyond, and there will be minimal surprises.

As uncertainty grows, either valuations drop or part of the purchase price is deferred and contingent upon customer and contract retention.

Sale of the small business to, or merger with, a large business, mandating a recertification that the seller cannot satisfy, will increase the uncertainty surrounding M&A transactions. It will be interesting to see how this plays out.

Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin, McLean, Va. He can be reached at jgrossman@hlhz.com.

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