Don't hit panic button on small-business contracts

Market Watch | Financial views of a competitive environment

The government contracting industry was caught off guard by the new Small Business Administration rule that goes into effect June 30, requiring recertification 30 days after closing an acquisition. It seems to many of us to be an overreaction to a lack of transparency on who actually holds small-business setaside contracts and penalizes companies that have successfully used the small-business contract program.

The new regulation will also, in all probability, result in agencies not being able to meet their small-business quotas and have a detrimental impact on the quality of contractors.

The adverse reaction by industry to these new regulations may result in a future re-examination or modification of the regulation. In the meantime, a lot of thought and analysis is being applied to what the liquidity and growth options are for companies affected by the new regulations.

Companies with small-business contracts have always faced challenges in attempting to sell their company to a large company or private- equity group. Although the new regulations create more uncertainty about whether the agency will exercise options or terminate a contract after notification that the contractor is no longer small, such transactions will still occur.

Purchasers will conduct additional due diligence relating to the company's relationship with the agency, the agency's need to achieve small-business quotas and the uniqueness of the company's skills and capabilities.

Buyers will also use earnouts or holdback arrangements tha postpone certain payments until the seller meets agreed-upon goals to mitigate small-business risk.

Other liquidity options for owners of companies with a preponderance of small-business contracts are:

  • Sale to high-net-worth individuals.
  • Certain forms of recapitalization.
  • Sale to an employee stock ownership program.
  • Go public.

As a result of the constant consolidation of the government services industry during the past 10 to 15 years, there are former owners of government service companies whose noncompete agreements have expired and who would like to invest in the industry again. Selling a controlling interest to one or more of these individuals does not require recertification.

Recapitalization of companies with small-business set-aside contracts also would not require recertification if it does not result in a change of control ? more than 50 percent ? and if the sources of the new capital do not have governance covenants that result in a negative control.

Such a recapitalization would typically include a combination of senior debt, subordinated debt and perhaps some minority equity. The uses of this new capital could be a combination of a dividend or capital gain to the owners and capital for acquisitions to let the company grow more rapidly and transition to full-and-open contracts.

The owners could sell to an employee stock ownership plan, which also does not require recertification. Some of the most successful government service companies are ESOPs because the status preserves corporate culture and creates increased employee retention and motivation. Examples are Science Applications International Corp., Alion Science and Technology Corp., and American Systems Corp.

Although the sale to the ESOP would not result in reducing the value of the small-business contracts because they continue with no risk of termination, valuations of a sale to an ESOP are generally less than the sale to a strategic buyer.

Finally, for larger companies — ones with $100 million plus in revenue — with long-term small-business set-aside contracts, typically with a 1,500-employee ceiling, going public is an option that does not require recertification. But only a handful of companies exist that can consider this option.

About the Author

Rick Knop is senior managing director and head of international banking investment at BB&T Capital Markets, of Reston, Va.

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