Ownership Rules May Trip Up SDV Companies By Dean S. Nordlinger In order to succeed, a service-disabled veteran-owned small business must walk a fine line between complying with applicable regulatory requirements and dealing with business realities. Nowhere is this tension more apparent than with respect to an SDVOSB’s ownership structure. Ideally, an SDVOSB’s governing documents will strike the proper balance between the applicable Small Business Administration and/or Department of Veterans Affairs regulatory requirements and the pursuit of its business objectives. However, as demonstrated by several SBA Office of Hearings and Appeals decisions surveyed in this article, careful planning is necessary to make sure the right balance is struck. Among the components of SDVOSB eligibility is the requirement that an SDVOSB must be at least 51% owned directly and unconditionally by one or more service-disabled veterans. The SBA regulations do not define what “direct” or “unconditional” means. Therefore, as an SDVOSB, you need to be aware of how the Office of Hearings and Appeals has interpreted and defined these terms, and how OHA’s rulings impact your corporate planning options. In 2006, OHA interpreted the words “direct” and “unconditional” in accordance with their plain and ordinary meanings as found in Webster’s dictionary. See The Wexford Group International, Inc., SBA No. SDV-105 (2006). In Wexford, OHA defined “direct” in relevant part as “from point to point without derivation . . . .” OHA also defined “unconditional” to mean the service-disabled veteran owner: (1) has immediate and full ownership of the company (or stock) without having to wait for future events; (2) is able to convey or transfer his ownership interest whenever and to whomever he chooses; and (3) upon departure, resignation, retirement, or death, still owns his stock and can do with it as he chooses. The Wexford definitions of “direct” and “unconditional” have since been adopted and often relied upon by the SBA and OHA as a de facto pass-fail standard by which a service-disabled veteran owner’s direct and unconditional ownership is determined. We believe the definition is too restrictive and ignores the realities of owning and operating a business with multiple, sophisticated owners. Indeed, service-disabled veteran owners, like owners of any other business, face numerous challenges as they attempt to develop and grow their companies, including attracting and retaining key employees and accessing capital. Placing too many restrictions on what service-disabled veteran owners can agree to in their governing documents with minority owners hampers service-disabled veteran owners’ ability to meet these challenges. After Wexford, several subsequent decisions have illustrated where OHA draws the line between corporate planning options that create impermissible conditions on ownership, and those that do not. Specifically, OHA has addressed the use of trusts, “drag-along” and “tag-along” rights, and rights of first refusal. OHA’s rulings on these planning tools provide some helpful insights into how these ownership provisions could be drafted to pass the Wexford test. Trusts: If a service-disabled veteran owner utilizes any form of trust, the trust should be revocable and the service-disabled veteran owner should be the grantor, trustee and current beneficiary of the trust. In Wexford, the service-disabled veteran owner’s ownership was deemed insufficient, in part, due to the use of an Employee Stock Ownership Plan (see ESOP explanation below) for which the service-disabled veteran owner: (i) did not serve as the trustee (contributing to a finding of the ownership not being sufficiently direct); and (ii) did not own unconditionally the shares of stock held by the ESOP. Basically, an ESOP is an employee benefit plan that is set up as a trust and makes the company’s employees partial owners of the company. The company makes annual equity contributions to the ESOP, which are allocated to the individual employee accounts. Typically, employees must vest, by years of service, in order to become entitled to the equity contributions in the individual employee accounts. Drag-Along and Tag-Along Rights: In order to attract key employees or passive investors, service-disabled veteran owners face the business reality of needing to provide some ownership protection to such individuals. To strengthen the notion of the service-disabled veteran owner being able to sell his ownership interest whenever and to whomever, while providing the minority owners some protection, the service-disabled veteran owner should consider incorporating “drag-along” and “tag-along” rights to the service-disabled veteran owner and minority owners, respectively. Through these provisions, the service-disabled veteran owner would have the right to compel (“drag along”) the minority owners to sell alongside and on the same terms as the service-disabled veteran owner if/when the service-disabled veteran owner determines the company should be sold. In exchange, the service-disabled veteran owner would grant the minority owners the right to sell alongside and on the same terms as the service-disabled veteran owner (“tag along”) if the service-disabled veteran owner declined to exercise his drag-along right when selling if/when he decides to sell his ownership inter- est or the company. However, when using drag-along and tag-along rights, service-disabled veteran owners must be careful not to give non-service-disabled veteran owners too much voice in the service-disabled veteran owner’s rights to sell his ownership interest. In Veterans Construction Services, Inc., SBA No. VET-167 (2009), OHA found that a supposed tag-along right created an impermissible condition on the service-disabled veteran owner’s ownership because the minority owner had too much say in the execution of the tag-along. Right of First Refusal: If a service-disabled veteran owner were to forego the preferred drag-along/tag-along structure above and instead provide a right of first refusal to the minority owner, the service-disabled veteran owner would be better served to include a qualified right of first refusal. A qualified right of first refusal would specify that the service-disabled veteran owner has the right to sell his ownership interest or the company to another service-disabled veteran or SDVOSB, in which case, the right of first refusal would be trumped and the minority owner(s) could be dragged along in the sale. To whatever extent the right of first refusal would be triggered, the purchase price for the service-disabled veteran owner’s ownership interest should be on arm’s-length terms, including a fair value purchase price. The danger of using an unqualified right of first refusal without arm’s-length terms was shown in International Logistics Group LLC, SBA No. VET-162 (2009). In this case, OHA found that a right of first refusal was an impermissible condition on the SDVO’s ownership because the right of first refusal was in favor of two specified individuals and further for a purchase price that would likely be deeply discounted below fair value. In sum, the existing case law regarding conditions on ownership of SDVOSBs instructs that to establish, preserve and defend (in a protest) eligibility, service-disabled veteran owners need to account for the Wexford test in structuring ownership provisions. Nonetheless, with careful attention to these sensitive issues, properly structured and narrowly tailored provisions (such as those noted above) should be includable in the SDVOSB entity’s governing documents without jeopardizing the business’s eligibility status. Dean S. Nordlinger, counsel with PilieroMazza, leads the firm’s Business & Corporate law practice. He can be reached at dnordlinger@pilieromazza.com.