Business Issues: Investing in SDV Companies By Dean Nordlinger The government contracting industry is robust and resilient. Since the latest economic downturn, strategic operators and financial investors alike (collectively, “investors”) have looked to the small business government contracting community as an area of potential growth and investment. In this context, service-disabled veteran-owned small business concerns (SDVOSBs) have received considerable attention. A successful SDVOSB investment strategy requires a delicate balancing of transactional concerns with the SBA regulatory requirements. This balance is all the more critical considering the SBA’s recent scrutiny of SDVOSBs and negative control (by minority shareholders/members) issues due to allegations of fraud and abuse in the program. Typically, investors seek to exercise as much oversight and control as possible over their investments. In the SDVOSB context, however, this creates an unavoidable tension with the SBA regulations. Those regulations impose certain parameters and limitations, the net effect of which requires investors to invest in SDVOSBs on a more passive basis. SBA regulations and requirements. Basically, there are two different SBA regulations at issue: the SDVOSB eligibility regulations and the size standard (affiliation) regulations. Broadly speaking, in order to be eligible to receive competitive or sole-source SDVOSB contracts, the concern must be an eligible SDVOSB and it also must be a small business under the size standard applicable to the government procurement. Investors need to carefully structure their investments to comply with these eligibility and size standard requirements, which if violated, could render the subject SDVOSBs ineligible to receive set-aside contracts. SDVOSB Eligibility. Background: To be an eligible SDVOSB, a concern must satisfy the following criteria: · it must be small (discussed further below); · it must be at least 51% owned by one or more service-disabled veterans; and · the management and day-to-day business operations of the concern must be controlled by one or more service-disabled veterans. What Constitutes “Control” Generally in SDVOSBs? Control by one or more service-disabled veterans means that both the concern’s long-term decision-making and day-to-day management and administration of its business operations must be conducted by one or more SDVs. An SDV must hold the highest officer position in the concern, usually president or CEO. The SDV need not have the technical expertise or licenses necessary to conduct the concern’s business if he demonstrates that he has ultimate managerial and supervisory control over those persons who do have the technical expertise or licenses. Protest and the Importance of Governing Documents: If the eligibility (or the size standard) of a SDVOSB became subject to a protest, the SBA would first review the concern’s governing documents, e.g., its articles of incorporation, bylaws and shareholders agreement. With that in mind, there is a certain tension and balance in these governing documents that investors need to achieve. Investors want them to contain sufficient investment-protective provisions that, if the SDVOSB’s eligibility were protested, would receive a passing grade from the SBA. SBA Disfavors Certain Traditional Investor-Protective Provisions: As a general rule, the SBA rejects the validity of unanimous or super-majority voting requirements except to the extent required by applicable state corporate law. States’ corporate laws vary. Accordingly, with respect to any particular investment, investors should analyze the corporate law of the state in which the subject SDVOSB is incorporated. Further, based on applicable case law, the service-disabled veteran must be able to sell, assign, transfer or otherwise dispose of his/her interest whenever and to whomever he/she chooses. Any encumbrances or conditions placed on the service-disabled veteran’s right to transfer (such as a “right of first refusal” in favor of investors) would be indicative of conditional ownership and could jeopardize the SDVOSBs’ eligibility and the investors’ investments. What Investor-Protective Provisions Might Be Acceptable under SBA Standards? In light of the regulatory disfavor shown to rights of first refusal, investors should consider certain other investor-protective provisions, which if carefully tailored, should not jeopardize the SDVOSB’s eligibility. Those provisions may include: (i) the investors’ right to participate in such transfer in the corresponding percentage of its investment on the same terms and conditions as the service-disabled veteran (a “tag-along right”); (ii) a right to sell back the investors’ ownership interest to the SDVOSB upon the occurrence of certain events (a “put right”); and (iii) the purchase of a key man insurance policy on the life of the service-disabled veteran owner would provide additional protection for the investors’ investment Small Business Eligibility. Background: In addition to the basic eligibility requirements, the SDVOSB also must be considered small under the applicable NAICS code assigned to the government procurement. To remain small, the SDVOSBs in which Investors invest must not be found to be affiliated with the investors by virtue of the investments (or otherwise). When and How is “Affiliation” Determined? The general rule regarding affiliation states that concerns and entities are “affiliates of each other when one controls or has the power to control the other, or a third party or parties controls or has the power to control both. It does not matter whether control is exercised, so long as the power to control exists.” Whether the SBA, based on investors’ investments, would find investors to be affiliated with the SDVOSBs would depend on the totality of the circumstances. However, common ownership, common control, financial dependence, and other contractual agreements and relationships are a few of the areas the SBA most uses to determine general affiliation. In practice, the SBA evaluates ownership on a fully-diluted basis (e.g., treats stock options as if exercised and as part of the SBVOSB’s capital structure) and has found a less than 50% as one indicia of potential affiliation. Simply put, the SBA has interpreted the applicable regulations as a basis to find de facto control in certain situations. The existence of multiple forms of assistance between two companies, such as licensing, bonding or support services, may lead to a totality of the circumstances affiliation finding. Investors should therefore consider limiting the occurrence of such dealings between themselves and the SDVOSBs. The goal is to avoid the appearance that the investors have any power to control the SDVOSB or that the SDVOSBs are reliant upon investors as a result of these contracts. Nonetheless, as and to the extent investors transact business with the SDVOSBs as part of any investments, the dealings should be in writing, arm’s length and otherwise commercially reasonable. Dean Nordlinger is counsel with PilieroMazza PLLC. Mr. Nordlinger represents companies, private equity firms, entrepreneurs and other clients on a variety of corporate matters across varied industries.