How to Navigate Small Business Status and Valuation in GovTech M&A

How to Navigate Small Business Status and Valuation in GovTech M&A

The GovTech M&A space has seen a flurry of activity as the U.S. economy recovers from the shocks of the COVID-19 pandemic. Before going on an M&A shopping spree, however, GovTech companies need to understand the unique factors at play and the impact that they’ll have during the M&A process.

In previous articles in this series, we’ve discussed set-aside contracts, i.e., U.S. federal contracts that are set aside for certain categories of businesses. For example, the U.S. federal government sets aside 23% of prime contracts to be awarded only to small businesses. In this third and final post in the series, we’ll discuss how to think about GovTech M&A valuations and negotiations, given the importance of set-aside contracts and small business status.

 

What If the New Business Is No Longer a Small Business?

Not every purchase of a small business will allow the merged entity to preserve small business status, since it may be too large to qualify. In this case, the merged entity can still acquire the original small business contracts, as long as they were properly transferred with a novation agreement according to the Anti-Assignment Act (see the second post in this series for a refresher on these concepts). In addition, the small business’ pending bids and proposals can also be transferred to the buyer.

The federal agency with which the contracts are signed will no longer be able to use the value of these contracts toward its set-aside contract goals (e.g., the 23% of prime contracts for small businesses). Once notified of the M&A deal, the agency cannot terminate any pending orders or decline to purchase minimum quantities under the contract. In most cases, the agency’s contracting officer will simply see the contract to the end of its term, accepting that the merged entity is no longer eligible to be counted toward its set-aside contract goals.

 

When Is Small Business Status Determined?

What if a small business is acquired (and loses its small business status) after submitting a bid for a new government technology contract, but before it wins the contract? According to 13 CFR § 121.404, the U.S. Small Business Administration (SBA) determines the size of a business when the business “submits a written self-certification that it is small… as part of its initial offer or response.”

In other words, the SBA assesses a company’s small business status based on the facts presented in its initial bid or proposal. Assuming the agency is properly notified following the M&A deal, this would not be a violation — but again, the agency would no longer be able to count this contract as part of its set-aside contract goals.

 

How to Think About Valuation for GovTech Small Businesses

So what does all this mean for the valuations of GovTech small businesses? You might think that this information makes small businesses and their assets inherently less valuable. After all, combining a smaller firm with a larger one puts the merged entity at risk of losing valuable set-aside contracts that are designated for small businesses.

However, this kind of simple, open-and-shut conclusion is not accurate when it comes to GovTech small business valuation. For example, buyers may be looking to purchase small businesses that have excelled at previous contracts with the same agency, due to talented personnel or valuable technology or resources. Even without small business status, acquiring these assets can help the merged entity win future contracts with the same agency — after all, there are still 77% of contracts up for grabs with GovTech firms that aren’t small businesses.

 

What Is the Present Effect Rule?

The SBA’s present effect rule is a regulation that may throw one last kink in the works during GovTech M&A negotiations.

According to 13 CFR § 121.103, ownership and control are the factors that affect whether a firm can be considered a small business. In particular, 13 CFR § 121.103(d) says that “agreements to merge (including agreements in principle)” may “have a present effect on the power to control a concern.” This means that preliminary documents during an M&A deal, such as a letter of intent (LOI), could potentially jeopardize a firm’s small business status.

In mergers and acquisitions, an LOI is a non-binding document that states the buyer’s intent to purchase the seller, including the proposed sale price, terms, conditions, assets, and liabilities. This document is usually signed before the buyer proceeds with the due diligence phase of M&A. Of course, an LOI is not a final agreement to merge, as the buyer may discover problems or irregularities during due diligence that cause it to pass on the deal.

The SBA treats agreements to merge as if the rights granted in them were exercised upon the document’s signature. However, the present effect rule also states that “open or continued merger or sale negotiations at some later date” are not agreements in principle, and thus are not given present effect.

If you’re uncertain about how an LOI might affect small business status, we recommend speaking with qualified legal counsel familiar with GovTech M&A matters.

 

Final Thoughts

Even if the merged entity loses small business status, in most cases it will still be able to carry out any existing small business contracts to the end of their lifetime. This means that the impact of small business status on GovTech M&A valuation is complex. Although losing this status will disqualify the merged entity from competing for 23% of federal contracts, there are still plenty of other contracts up for grabs — and the potential loss of income may be outweighed by other benefits of the deal, such as acquiring new skills and technologies.

From the Anti-Assignment Act to the Present Effect Rule, there are a variety of regulations that GovTech firms need to know when negotiating M&A deals. If you need help, advice, or legal counsel with your upcoming M&A transaction, please get in touch with our team of experts today for a chat about your business needs and objectives.