Understanding the Impact of Set-Aside Contracts on GovTech M&A

After the economic downturn of 2020 induced by the COVID-19 pandemic, things are looking up for 2021 and beyond. In Q1 2021, U.S. GDP grew by a blistering 6.4%, with unemployment claims reaching a new low since the start of the pandemic.

2021 has also seen a flurry of activity for GovTech mergers and acquisitions, such as Tyler Technologies’ $2.3 billion purchase of NIC — the largest GovTech M&A transaction ever. Many GovTech firms see the post-pandemic economy as the perfect opportunity to snap up other companies at a discount. In particular, mid-size government contractors with aggressive growth strategies are repeatedly looking at the small business arena for their targets.

But while M&A can be a smart strategy to grow your GovTech business, there are a few issues you need to be aware of before you get started. In this three-part blog series, we’ll take a look at how GovTech firms can best navigate the M&A landscape. This first post will examine the role of set-aside contracts in GovTech M&A, and their potential impact — both positive and negative — on your next GovTech M&A deal


What Are Set-Aside Contracts?

Since the U.S. Small Business Administration (SBA) was founded in 1953, the federal government has required a certain percentage of contracts — currently 23% of prime contracts—to be awarded to small businesses. These federal contracts for small business are known as “set-aside contracts,” since they are “set aside” explicitly for certain types of businesses.

Small businesses are not the only category of set-aside contracts, however. The federal government’s goals for set-aside contracts include:

  • 23% of prime contracts for small businesses.
  • 5% of prime contracts and subcontracts for small businesses owned by women.
  • 5% of prime contracts and subcontracts for small disadvantaged businesses.
  • 3% of prime contracts and subcontracts for HUBZone small businesses.
  • 3% of prime contracts and subcontracts for small businesses owned by veterans who were disabled in the line of duty

“Small disadvantaged businesses” are small businesses that are majority-owned by one or more individuals considered socially and economically disadvantaged. HUBZone small businesses are small businesses that operate in a historically underutilized business zone — typically areas with a household income or unemployment rate that significantly underperforms the statewide average.

The federal government’s objective in providing set-aside contracts is to enable smaller or disadvantaged businesses to compete on equal footing with larger, more established firms. To qualify for set-aside contracts, businesses must have registered their status with the U.S. System for Award Management (SAM).


The Impact of Set-Aside Contracts on GovTech M&A

Due to these set-aside contract regulations, the federal government usually prefers to work with small businesses whenever possible, since they can help meet these set-aside contract goals. In fact, according to the U.S. General Services Administration, “Every federal government purchase between $10,000 and $250,000 is automatically set aside for small businesses, as long as there are at least two companies that can provide the product or service at a fair and reasonable price.”

It’s not hard to see, then, why small business status is considered so valuable for companies that contract with the federal government. To this end, the SBA offers a Size Standards Tool to help companies determine if they meet the formal definition of a small business.

Because small business status — and the contracts it can entail — is so valuable, it should be treated as a potential asset during M&A negotiations for GovTech firms. Specifically, if your GovTech firm is looking to acquire a small business, you need to be conscious of SBA rules regarding set-aside contracts and how the proposed M&A deal would affect the status of both buyer and seller.

For example, the due diligence process might reveal that the seller or buyer would lose its small business status after the acquisition, or that the government may terminate an existing small business set-aside contract. In this case, you should consider adjusting your purchase price to account for the revenues that would be lost as a result of losing set-aside contracts.

Even if the merged entity would still have small business status, it may be necessary to structure the new organization in a certain way to retain its existing contracts. For example, the SBA requires women-owned and service-disabled veteran-owned businesses to be “51% or more owned, controlled, and primarily managed” by individuals in these categories.


Final Thoughts

Set-aside contracts are an essential concern for GovTech M&A deals. A company’s small business status can be a valuable bargaining chip for negotiations, but also a source of concern if the merged entity would no longer be eligible for federal set-aside contracts.

But what about set-aside contracts the seller has already won and is currently in the process of completing? We’ll focus on this question in our next article in the series, which will go over how and why set-aside contracts are transferred. You can also get in touch with our team of experts today if you need help, advice, or legal counsel with your upcoming M&A deal.