This article is Part I of a series of articles that analyzes your company from a potential buyer’s perspective, and offers strategies that you can implement to increase the value of your company. This article will focus on your contracts and how they impact your overall valuation.

      As a government contractor, your contracts are your lifeblood. However, not all contracts are valued equally by a prospective buyer. Various contracts have differing positive attributes as well as differing levels of risk associated with them. In valuing a company, it is important to note that the greater the risks associated with a selling company, the lower the overall valuation. The inverse also is true. Thus, reducing risk is one way of improving a company’s valuation.

Prime vs. Subcontracts

      Companies generally have a mix of revenue, generated from both prime contracts with the government as well as subcontracts to primes. In the eyes of a buyer, the revenue derived from a prime contract is worth more than subcontract revenue.

      There are a couple of reasons for this. First, a prospective buyer desires control over the contractual effort and direct access to the customer. This permits them to solidify the customer relationship as well as provide the opportunity to cross-sell other products and services.

      Secondly, many subcontracts contain termination provisions in case of change of control of the company. These provisions increase the risk that the revenue generated from the subcontract may be reduced or eliminated upon a sale transaction.

Set-Asides vs. Full-and-Open Contracts

      Set-aside contracts, whether 8(a), small business, HUBZone, etc., are worth less to a prospective buyer, sometimes significantly less, than contracts won in full and open competition.

      Most small companies eligible for set-asides lack the capital, or the access to debt, to execute an acquisition transaction. Most buyers are larger companies that would not qualify for set-aside opportunities.

      There exist restrictions on the transferability of set-aside contracts to companies that are not eligible for set-asides, making it difficult or prohibitive to execute such a transfer.

      For instance, all 8(a) contracts contain a provision that if the 8(a) company is sold to a firm not qualified to be 8(a), the government has the right to immediately terminate the contract. It has been my experience that this provision is mostly not utilized by the government. However, the potential risk of this occurring always exists.

      Secondly, small business set-aside contracts contain a provision that upon sale of the company, the acquirer has to “recertify” its small business size status. If they are unable to recertify, the companies face the risk that the government may not exercise future option periods. The large buyer would also be ineligible to bid on the recompeted contract (as the prime) if the contract were to remain in the small business program.

      Full and open contracts do not contain these restrictive provisions. Thus, a prospective buyer is willing to pay more for a company with these types of contracts than those with set-aside contracts.

Contract Type

      The type of contract you are performing under (Cost Plus, Time & Materials, Firm Fixed Price) also carries differing valuations for the revenue they generate. The primary reason for this is the opportunity (or lack thereof) to earn higher profit margins on the contractual work effort.

      The profit percentages of Cost Plus contracts are most often fixed and are on the low end of the profit scale. This is due to the fact that performance risk remains with the government in these types of contracts. Regardless of whether the buyer is able to bring about greater efficiencies during contract performance or lower costs, the profit percentage/amount earned will not vary. Thus, the lowest valuations are placed on cost-plus contracts.

      Time & Materials and Firm Fixed Price contracts afford the buyer opportunities to earn higher profit margins. This is especially true if the buyer is able to provide greater work efficiencies or lower costs. Higher valuations are placed on these types of contracts.

Schedules/IDIQ/GWACs

      Depending on the contract or vehicle, these can have potential value, especially in the eyes of a strategic buyer. Understand that these types of vehicles are merely hunting licenses; however, they can be quite attractive to a prospective buyer, especially if that buyer does not currently possess such vehicles or was one of the losers in the competition of such contracts.

Conclusion

      As this article discusses, the value of a contract revenue dollar can vary greatly depending on the nature and type of contract you are performing under. Understanding these distinctions from a buyer’s perspective can help guide you to maximize the Company’s value as part of your annual strategic planning process.

     The series - coming soon:

• Part II - Financial Performance
• Part III – Management Infrastructure
• Part IV – Product/Service Offering

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 and technology industries. He can be reached via email at MikeS@FedStrat.com.