Business Issues: Valuation of an 8(a) Company By Michael Smigocki, CPA In February 2011, the SBA made significant regulatory changes to the 8(a) program. One of the changes was to further define who is considered economically disadvantaged. Previously the SBA had utilized an applicant’s total assets as a basis for denying participation in the program. However, a threshold amount was never established. Thus, it was up to the discretion of the SBA to determine this. Under the new regulations, total assets of the applicant cannot exceed $4 million, and while in the program they cannot exceed $6 million. What many people do not realize is that a business owner’s total assets include the value of the 8(a) business. Valuation of a closely-held business is a very imprecise science. There are a large number of variables that go into valuing such a business and a wide range of values can result. This is true for the government contracting industry, and 8(a) companies in particular. This article is meant to address some of these variables that should be considered when valuing your 8(a) business to ensure your entry into and continued participation in the program. The regulations provide very little guidance to the participant on how to value the business other than to say the “fair market value” of the asset (the 8(a) business) is to be included in the total asset test. The most widely recognized definition of fair market value is provided to us by the IRS. Internal Revenue Ruling 59-60 states that “Fair market value is the amount a buyer is willing to pay and a seller is willing to accept if neither is under a compulsion to act and if both parties are fully aware of all pertinent facts.” Thus, the valuation should be taken from the perspective of a willing buyer purchasing the company from a willing seller. There are a number of different valuation approaches (market, income, asset) as well as a number of different valuation methodologies (comparable sales, price earnings, capitalization of earnings, discounted future cash flows, adjusted net asset, etc.) used to compute fair market value. The selection of an appropriate approach and methodology is a critical decision because a wide range of values can result from the various approaches and methodologies. When valuing a government contractor, and specifically an 8(a) company, there are certain nuances that need to be taken into consideration. Some of these include: 1. Government contracts and the revenue stream they generate are not all worth the same. There are different means of obtaining government contracts including full and open competition, 8(a) and other set-aside programs. It is important to note that full and open competition contracts are worth more than any form of set-aside contracts. 8(a) contracts are worth the least due to the fact that 8(a) contracts contain a provision for possible immediate termination should the contract or company be sold to a non-8(a) qualified company. Any valuation of an 8(a) company must take this factor into consideration else you are running the risk of over-valuing the business. 2. The marketability of the 8(a) is very low. There is very little market interest in acquiring an 8(a) company by a non-8(a) company. This is because of the lack of transferability of the contracts. Those companies that would be interested are generally other 8(a) companies, though they lack the financial resources to execute such a transaction. When valuing the 8(a) company, a high discount for lack of marketability should be utilized. 3. Different contract types carry different market values. A fixed price contract is generally worth more than a T&M contract, and both are generally worth more than a cost-plus contract. This is because of the profit potential of each of the contract types. 4. Government contracts can be terminated for convenience or option years not exercised. The government contract industry provides a unique risk factor that must be taken into consideration when valuing a business. Even though many of the contracts are long-term, the government has the unilateral right to terminate the contract for any reason it wants. In addition, it can choose not to exercise option years on the contract. These facts can call into question the future revenue stream and the benefits to be received from the contracts in the future. The new regulations do not allow for much growth in value of your 8(a) business over the course of the program. Improperly valuing your business can lead to premature graduation from the program. Participants should work closely with valuation experts who understand the nuances of the government contracting industry. 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, valuation, forensic accounting and expert testimony services to the government contracting industry. He can be reached via email at MikeS@FedStrat.com.