It seems that “small,” at least in the context of the Small Business Administration (SBA), doesn’t always mean what it says.

Sen. John Kerry, chair of the Senate Committee on Small Business and Entrepreneurship, made the point during a hearing on “Increasing Government Accountability and Ensuring Fairness in Small Business [Government] Contracting” in July.

In his opening statement Kerry noted that six of the top 30 small business government contractors are actually large businesses. He illustrated this fact with a large poster that named BAE, General Dynamics, L-3, Lockheed Martin, Northrop Grumman and SAIC as the culprits.

Which is not to suggest these corporations are guilty of wrongdoing. The inclusion of large companies in the list is the product of a gaping loophole in SBA certification requirements that allowed businesses to maintain their small status indefinitely–even if they grew beyond small business status organically or through merger.

“Businesses had to recertify if there was an asset purchase but not if there was a share purchase, so many mergers or acquisitions were structured as changes of ownership to maintain small business status,” says Holly Svetz, a partner at Womble Carlyle Sandridge & Rice.

But in November 2006 the SBA moved to close the loophole, announcing new recertification rules that took effect this summer. “The main change is that small businesses will lose their status if they become affiliated with a larger business,” Svetz says.

And that means companies large and small that are thinking of acquiring small business contractors will have to be much more careful in evaluating their prospective targets.

Closing a Loophole
Historically the SBA determined small business status on the date a firm submitted its offer to fulfill a federal contract. Characterization of the firms as “small” lasted for the duration of the contract.

“The previous law meant that some long-term contracts, with options, permitted companies to retain their ‘small’ status for 10 to 20 years, regardless of whether a company went from being a small company to a large company during that period,” says David Hickey, counsel with Greenberg Traurig.

The new rules affect small businesses holding long-term contracts, defined as agreements longer than five years, including options. These businesses must now certify they are still small 60 days to 120 days before the sixth year of contract performance.

In addition the new rules require recertification within 30 days of an asset or stock purchase becoming final.

“This aspect of the rules closes a loophole that encouraged or fostered acquisitions of small companies by larger companies,” says Richard Rector, chair of DLA Piper’s government contracts practice. “The underlying motivation for these acquisitions was that government agencies had to meet certain quotas in dealing with small business. If the agencies could meet those requirements by awarding contracts to enterprises that qualified as small businesses but had all the resources of a large business, it was the best of both worlds for them.”

Bottom Line Impact
“If a small business loses its designation, it’s no longer eligible for certain special competitive preferences when the government awards contracts,” Rector says. “Suddenly a small business that has merged has to compete in the deep end with all the other big fish.”

Although loss of small business status does not require termination of existing contracts, it does jeopardize future revenues. “The bottom line is that when a business can no longer certify that it is small, the contracting officer must decide whether or not to exercise the next option under the contract,” Hickey says. “But because the agency will not get small business credit toward its SBA quota, option exercise is less likely, thus impacting revenues and valuation for small businesses.”

In addition, a July 2007 letter from SBA Administrator Steven Preston and a subsequent press release suggest the SBA intends to extend the recertification requirement to future as well as past mergers and acquisitions. According to the release, the SBA believes the new rules are applicable to all long-term contracts held by firms that have been through a merger or acquisition–even if the transaction occurred before June 30. Because this interpretation raises serious legal questions, the situation remains uncertain for the time being.

Aggravating the uncertainty are the SBA’s broad affiliation rules, under which the loosest of ownership connections can result in a loss of small business status. For example, the SBA has on three occasions refused to recognize the eligibility of companies that would otherwise qualify as small because they were part of a private equity fund’s portfolio. With the new recertification rules, affiliation problems are likely to multiply.

Kerry’s Mission
“Federal government contracting officers aren’t trained to deal with the complex corporate situations that exist in the market these days,” Svetz says. “They’re used to a Lockheed Martin type of arrangement with three corporate entities and five business units–period. The difficulty is that the affiliation rules haven’t quite caught up to the market.”

And given the prevailing political atmosphere, things aren’t likely to get much better. “The new Democratic majority means the small business lobby has a lot of support in Congress,” Svetz says. “Senator Kerry’s committee, for example, has proposed that Congress increase the federal quota for awarding small business contracts from the current 22 percent to 30 percent in 2008.”

In May, as Kerry’s committee began considering a House bill that proposes annual size recertification in certain cases, he expressly stated that Congress could “do better” than the SBA’s five-year recertification requirement.

“Why should we allow big businesses to get small business set-aside contacts for one day, let alone five years?” he asked.