Recertification: One year later

Market Watch | Financial views of a competitive environment

The Small Business Administration implemented a rule
that became effective June 30, 2007, and requires
companies that have been acquired to recertify their small-company
status within 30 days of the deal closing. This
rule has significantly altered transaction structures and valuations
in the government services mergers and acquisitions market.

The level of uncertainty surrounding the
transferability of contracts and sustainability
of relationships has materially increased, at
least in the minds of active buyers. For most
transactions involving small businesses, fewer
buyers are taking a serious look, and for those
considering an offer, scrutiny has increased
and due diligence has deepened. What's more,
pricing and terms have changed in the buyers'
favor.

In those instances when a company fails to
recertify as small, the government customer
loses small-business credit for all future business
with that contractor. Before a more reasoned
response to these rules can be developed,
further industry experience with government
contracting officers' behavior is
needed. Government actions will vary by
agency and by contract type and duration.
For now and in the short term, recertification
rules have changed the marketability and
valuation in the small-business arena. These
rules are important because small businesses
? those with less than $50 million in revenue
? represent more than two-thirds of government
services M&A transactions.

In some instances, these cautious buyer
reactions make sense. In other instances, good
small businesses will be overlooked.

Here are some of the issues and factors
involved: There is no requirement that the
government take any action because of the
failure of an acquired small business to recertify.
The acquired contractor is highly likely to
continue to perform the work for the duration
of the contract. The government customer
would have to invoke the termination-for-convenience
option to remove the contractor
before the end of the contract period. Option
years provide the first clear opportunity for
the government to change contractors by failing
to exercise those options.

Most government contract offices are busy
enough without the extra effort of replacing
contractors that are performing well.

However, there will be instances when an
agency's small-business contracting goals are
important enough to warrant the extra effort
required to replace an existing contractor to
retain small-business credit. I expect that
would be the exception rather than the common
practice, even though many contracts
contain small-business utilization targets.

Most government agencies are sensitive to
the proportion of their contracting volume
represented by small businesses. Provisions
in the Federal Acquisition Regulation provide
guidance on small-business utilization
for prime contracts and subcontract positions.

To one degree or another, agency
heads, the administration and members of
Congress monitor the level of small-business
revenues to determine whether
targets are being met.

The effects of these government regulations
and small-business goals, generally
shared by Congress, must be understood in
a real-world context. What will matter
to government contracting officers
when deciding how to respond
to a failure to recertify as small?

The historical record of generally
solid contractor performance,
heavy contract office workloads,
high switching costs and the extra
effort required to change the status
quo suggest that business continuity
is likely. Under the new rules, sustaining
small-business contracts and maintaining
customer relationships will be similar to
historical experience.

Although buyers must make a greater
effort in due diligence to ferret out the
great small companies with sustainable
businesses, the effort can pay off, as it has
historically.

Jerry Grossman (jgrossman@hlhz.com) is managing
director at Houlihan Lokey Howard and Zukin.

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