The SBA may be on the verge of passing a new rule that could increase the size standard for small businesses to as much as $531M. If the SBA makes the rule official, it is going to have big implications for most small and mid-sized government contracting companies.
If you are the owner, exec or advisor of a small GovCon company, you should gain an understanding of the potential impact to your positioning and strategy. You should also do it soon because the SBA may well make the rule official this Fall.
The new rule would change potential universe of buyers for companies; which small businesses a given buyer will consider acquiring, how much they will pay for it; what happens on certain IDIQ contract vehicles; what happens to existing JV’s and what new JV’s may be needed; what constitutes a lifestyle business; which parts of your pipeline have the most value; which potential sellers might have the most immediate benefit from the new rule if they are positioned for first-mover advantage; and many other things.
Most of the companies we work with provide professional services to the Federal government, mostly different types of information technology, engineering or intelligence analysis services. This article is meant to give owners of such companies an overview of some of the implications to get their thinking started.
Will you really be competing against $300-500M companies?
Yes, this rule change would mean many mid-sized companies will suddenly qualify once again as small businesses. Let’s call them Small Businesses – Round 2 (SB-2). Many business owners we talk to seem to have the reaction “OMG I won’t be able to compete with $500M companies!” but let’s think it through. There are only so many mid-sized companies which means there will only be so many SB-2 companies. Not many companies reach that size and those that do are frequently acquired.
More importantly, private equity firms acquire a lot of the mid-sized companies as platform companies and those companies are unlikely to qualify as a small business even under much higher size standards due to the rules of affiliation (e.g., those companies will still be affiliated with the PE firm’s other companies for purposes of determining size). The exception would be companies acquired by PE firms using SBIC funds but there are not many such companies.
Further, the Holy Grail in government contracting will remain the transition to 100% full & open (F&O) revenue and the higher valuation multiples that brings. Sure, a company with $100-500M of revenue would become an SB-2 company and once again be eligible to pursue small business contracts but if they were already well on their way transitioning to F&O revenue, and therefore higher valuations, will they really want to dilute that value by loading up on a bunch of small business revenue? Doing so would mean facing transition to F&O a second time only this time needing to replace hundreds of millions in small business revenue in order to transition.
It seems more likely that SB-2 companies currently in the $50-150M range whose revenue is still primarily small business revenue will take most advantage of growing towards that $500M mark using small business revenue. The ability to grow bigger, build a stronger management team and additional past performance qualifications before transitioning to F&O will be tempting.
If those $50-150M businesses are the primary companies choosing that route, it means traditional small businesses will mostly be competing with companies only somewhat larger than themselves and not against companies in the $300-500M range.
Companies in that $50-150M range will eventually become $500M companies but by then your company should have been growing right along with them. So the scenario with $10-20M revenue companies competing against $500M companies is likely a few years down the road. It would be coming eventually, but won’t be the immediate problem that many people think.
One exception to this, however, would be small businesses and some SB-2 companies that take advantage of the high size standard to acquire other SB and SB-2 companies to form very large companies. We should expect to see a few such companies formed.
What the new rule would mean for companies considering selling now
For starters, the higher size standard may make your business worth more. If you are nearing your current size standard, it means the likely buyers are already large businesses in which case they will most likely attribute no value to your small business IDIQ’s because they can no longer use them to pursue new task orders. Similarly they will attribute no value to small business opportunities in your pipeline because they cannot pursue them under the current SBA rules.
For owners running a $20-30M revenue company, under the proposed rule suddenly larger buyers could consider acquiring you and still be able to recertify as a small business themselves post closing. That means they should be willing to attribute more value to the acquisition of your company because your small business IDIQ contracts and small business pipeline can still be leveraged.
Should some companies consider selling if the rule becomes effective?
If you are having trouble competing anyway and see that the competitive environment may become even more competitive in your market segments over the next few years then yes, you may want to consider selling.
It may seem counterintuitive but if the proposed rule is made effective you also might want to consider selling if you have a company with a great portfolio of small business contract vehicles, at least if you were otherwise considering selling over the next couple of years. This is because many SB-2’s did not qualify to bid the recent GWACs like Polaris, SEWP VI and OASIS+. True, the onramp for OASIS+ Small Business is currently open but that may change.
In the immediate aftermath of a big increase in the size standards, some of these SB2’s will likely pay a premium to snatch up companies to gain access to one or more best in class small business GWACs. That means a window of opportunity for a select few sellers immediately after the new rule takes effect.
There would be some upsides for small business owners
Suddenly you would have much more breathing room than you do now in order to build a strong company before no longer qualifying as a small business. Mostly companies in the mid-$30M’s of revenue have limited management teams and infrastructure because a business of that size has limited indirect budgets.
Such companies also typically do not qualify to win F&O contract vehicles and therefore F&O work with which to better survive the transition to being a F&O company. A friend of mine refers to many F&O contracts as “large business set-asides” because the scoring is geared such that only the largest companies can win and makes it impossible for companies in the $50-150M range to compete. Even if your company has the capabilities, if the solicitation requires 3 prime past performance quals of $100M TCV or more, how many companies meet that requirement?
Much higher size standards would mean you could grow your company to $500M on small business contracts which is an entirely different matter. That is a whole different level of past performances and capabilities with which to compete. That could also give you a higher probability of making the transition from small business to F&O successfully.
The rule would also make for an entirely different level of lifestyle business. We have all seen companies that sit around $20-30M in revenue year after year with an owner who is content with the level of profitability they can take home and not have to fight the hard transition to F&O. Imagine if they could grow a lifestyle business that is $500M in revenue and $50M in annual profits. That would be quite the lifestyle.
There would be opportunities for acquisitive owners too
Much higher size standards would certainly provide an unusual opportunity to become a buyer of one or potentially even several other companies while remaining a small business yourself.
Acquisitions can be a great way to add customers, capabilities and contracts but in the GovCon market owners have to be extremely careful not to make an acquisition if the 5 year average revenue of the combined companies is going to push you beyond your small business size standard.
A much higher size standard changes that entirely. If your company is nearing today’s size standard you are likely limiting yourself to organic growth to avoid immediately triggering a recert as a large business. If the SBA makes a big increase in the size standards, the benefits of M&A will once again be available to you.
A quick run through other potential impacts
Rule of 2: Under the Rule of 2 the government is supposed to set-aside work for small businesses if two or more small businesses are qualified to perform the work at a competitive price. Under a $500M size standard, it would stand to reason that a lot more work – and larger contracts – could go small business set-aside because small businesses in the $100-500M range will suddenly qualify when the government applies the Rule of 2.
Joint Ventures: As they outgrow their size standards, many companies set up JV’s with smaller companies. The basic goal is to allow them to pursue the recompetes of their own work through a JV that still qualifies as a small business. Lots of smaller companies have entered into these JV’s hoping to pick-up their share of that work if their JV wins the recompete. If the larger companies in these JV’s suddenly become SB-2, however, they will no longer have an incentive to bid their small business recompetes through the JV. It will make more sense for them to pursue it as prime, leaving small JV partners out.
New companies and very small companies: These companies may be the hardest hit if they don’t have a good differentiator or customer intimacy on the part of the owner from past roles in other companies. This may cause more companies in this size range to pursue subcontract work. But there is nothing the matter with starting a company on the back of subcontract work, it is a tried-and-true way to build a company and gain past performance quals and capabilities.
