Has SBA Destroyed Your Company's Valuation? By Michael Smigocki, CPA You have been reading in this publication and others about the new rules governing small business recertification. These rules can possibly have a dramatic impact on the value of your business as well as the overall marketability of the company. Under previous SBA regulations, a company’s size status was determined at the time of contract award. This designation was retained for the life of the contract. Also, under previous regulations, if a large contractor acquired a small business with set-aside contracts, the large contractor was able to continue contract performance through the remaining life of the contract. This has always been an important factor when a large company buys a small business. These regulations had also applied to 8(a) contracts. If a company was a qualified 8(a) contractor at the time of contract award, it was able to continue contract performance through the life of the contract even if the company graduated from the 8(a) program. One difference between 8(a) contracts and small business set-aside contracts is that 8(a) contracts contain a provision that if the contract or the company were to be acquired by a non-8(a) qualified company, the government could immediately terminate the 8(a) contract. This provision resulted in much lower valuations for 8(a) contractors versus other contractors. The new regulations, effective June 30, should help achieve the SBA’s objective of ensuring that small business contracts and task orders are going to actual small businesses. A study by Eagle Eye Publishing found that contractors such as Boeing, Lockheed Martin, Northrop Grumman, SAIC and General Dynamics, among others, were performing work under small business set-aside contracts. These contracts were, of course, obtained through the acquisition of small businesses by the large contractors. In addition, the government was taking credit for these as small business contracts in reporting their small business goals even though they were performed by the nation’s largest contractors. Impact on Valuation There are, in essence, two types of buyers in the marketplace: financial and strategic. Financial buyers are looking to make a return on their initial investment above and beyond what they could earn elsewhere (such as by investing in publicly-traded stocks, bonds, real estate, etc.). Owning a privately held business involves significantly more risk than these other types of investments, so they seek much greater returns. There is an inverse relationship between risk and valuation: the higher the risk, the lower the valuation. Thus, financial buyers typically will value a company at lower levels in order to obtain higher returns. Strategic buyers are acquiring companies for reasons other than just financial (i.e. product/service offering, agency relationships, intellectual property, contract backlog, etc.), though financial performance is a considerable factor. Because of the other factors being considered in their acquisition decision, strategic buyers are generally willing to pay more for a company than a financial buyer. The new regulations will affect both types of buyers. Upon sale of the company, the acquirer will have to recertify as small or, if it is not, it will not be eligible for small business set-asides. When establishing an acquisition price, both types of buyers project the anticipated revenues and earnings of the seller. A significant factor in this analysis is the company’s contract backlog. The new regulation can have a material impact on the contract backlog of the seller and will result in a lower valuation. Strategic buyers can be further affected due to the other losses than can occur with the loss of these contracts. These include: •Loss of project management and a skilled workforce performing under these contracts; •Loss of customer/agency relationships; •Loss of ability to cross-sell other product/service offerings to customers; •Loss of possible ability to perform follow-on contracts. The end result will be a lower valuation for these contractors. Impact on Marketability In addition to the impact on valuation, the marketability of the company will also be affected. Marketability is the ability to convert an asset (i.e. the value of the company) into cash. Different types of assets are more readily converted to cash. Selling the stock of a closely held company is already a difficult and arduous task. Even the most attractive closely held companies generally take 6-9 months to complete a sale. The marketability of a closely held contractor with these long-term contracts has now been impacted by the recertification rules because the pool of potential buyers has been significantly reduced. While a large contractor may still be interested in purchasing the company for the other contracts and capabilities the company may have, the loss of the ability to continue performance under set-aside contracts will significantly reduce this interest. In addition, small contractors who would be able to recertify as small, for the most part, do not have the financial resources to execute such an acquisition. It should be further noted that the cost and effort of acquiring a small contractor is generally the same as that of acquiring mid-sized and larger contractors for the prospective buyer. Because of this, these buyers tend to shy away from smaller deals unless there is a compelling reason to pursue them. Eliminating the ability to continue performance under these contracts will further dampen the interest of these prospective buyers in smaller deals. Conclusion The goals of the recertification rules are to increase the opportunities available for small businesses and to improve the reporting of small business awards. The new rules should go a long way towards achieving these goals. However, a consequence of these new rules is a significant reduction of the value and marketability of small contractors. (Michael Smigocki, CPA, CVA, ABV is the senior managing director of Federal Strategies Group LLC. He provides government contract and management consulting, M&A advisory, forensic accounting and expert testimony services to the government contracting industry. He can be reached via email at MikeS@FedStrat.com.)