M&A Special Report: New small-biz rule could dampen M&As

A company's portfolio of contracts is a key factor potential acquirers evaluate when making deals. But a new rule that takes effect July 1 could make small businesses much less appealing.

The Small Business Administration rule will require a small business to recertify its size when it gets acquired. If the acquisition pushes a company out of the small-business category, its contracts will no longer count toward agencies' small-business goals.

Although observers doubt that agencies would terminate contracts after an acquisition, the government might choose to not exercise option years before reaching maximum term.

The result might be a dampening of valuations for small businesses, particularly ones that provide common IT services.

"There's going to be a lot more due diligence done by buyers," who will now place more weight on other aspects of the company, said Rick Knop, senior managing director at the investment bank BB&T Capital Markets. "This is not a positive thing for the industry. I think the government is going to get unintended consequences here."

On the other side of the fence, however, the rule may be a boon for larger companies, which will be able to spend less money to acquire a small firm, said Shiv Krishnan, president and chief executive officer of Indus Corp., based in Vienna, Va.

"It does increase the level of risk," Krishnan said. "The immediate thinking is that we will not be willing to pay a lot of money to buy these companies even when we acquire. If I don't have to pay $10 million, if I can pay $5 million, that's a benefit to me."

When CACI International Inc. bought AlphaInsight Corp. in 2006, it got a company that was not resting on its small business status. Vish Varma, former vice president of corporate development at AlphaInsight and now senior vice president at CACI, said AlphaInsight spent three years building the company as a skilled security firm with security-cleared personnel. That gave it a value beyond the short-term revenue stream, Varma said.

"You need a little bit of a runway," he said. "If we have a small business to sell, we should give ourselves a runway of at least two years if not more."

Acquiring companies should look past the contract portfolio to consider factors including a small business' technology, market intelligence and established relationships with customer agencies, said Larry Allen, executive vice president of the Coalition for Government Procurement.

Even under current rules, companies that acquire small businesses usually can't bid to keep the contracts that were awarded as small-business set asides once they expire, said Larry Davis, managing partner of Aronson Capital Partners. The new rule "is like putting a speed bump into a process that already has a lot of speed bumps," he said.

Computer Sciences Corp. has not actively pursued small businesses, in part because the value of their contract portfolios is somewhat unpredictable. The new rule will only heighten that trend, said James Sheaffer, president of CSC's federal sector. When CSC acquires small firms, such as Datatrac Information Services Inc., based in Richardson, Texas, it has done so because the company was attractive for other reasons, he said.

"We looked very carefully and saw that [Datatrac] had successfully moved beyond small-business contracts," he said. "We saw value based on the willingness to compete and win contracts without that advantage."

Other small businesses looking for a buyer will have to show the same willingness, he said.

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