Start-Ups Planning to Pursue Small Business Set-Aside Contracts Face Unique Compliance Issues
June 22, 2017
By: Eric Whytsell
Starting a business is not for the faint of heart. Establishing and operating a start-up always entails careful consideration of a wide variety of legal and practical issues. Success or failure can depend on the choice of entity, agreed-upon buy-out provisions, the selection of teammates and suppliers, or any of a multitude of other key decisions. When a firm’s business plan includes the pursuit of federal small business set-aside contracts, however, its owners must also consider compliance issues that do not apply to other businesses.
In addition to standard government procurement rules (which can pose their own challenges), businesses that want to win federal set aside contracts must comply with special rules in order to establish their eligibility for such awards. The specific requirements that apply vary depending on the particular type of small business contemplated (e.g. woman-owned small business; service-disabled veteran-owned small business, 8(a) small disadvantaged business). But most prospective owners will need to answer two fundamental questions, each of which can involve a number of interrelated inquiries: (1) will our business be a “small business”? and (2) does the business qualify as the specific type of small business we want it to be?
Will the Business Be a “Small Business”?
This question can be surprisingly hard to answer, even for a start-up. Indeed, for a wide range of government contractors the answer is not “Yes” or “No” but instead “It depends”. For set-aside purposes, the federal government defines what constitutes a small business on a contract-by-contract basis. Each solicitation is assigned a North American Industry Classification Systems (NAICS) code and each code has a corresponding size standard based on either the number of employees or average annual revenue. Because smallness is determined at the solicitation/contract level, a contractor with $10 million in average annual revenues would be a small business with respect to a procurement with a $20 million size standard but too big to compete for a contract subject to a $7.5 million size standard.
Despite this, it still might seem fairly easy to answer the “small business” question for a new company. It is tempting to think that all start-ups are automatically small, either because they don’t have many employees or because they don’t have any revenues yet. But that notion may prove to be wrong. When comparing the number of employees or annual revenues to the applicable size standard, the federal government considers not only the employees or revenues of the start-up itself but also those of any of its “affiliates”. In many cases where an affiliate’s employees or revenues are added to those of the start-up, the affiliation rules render the start-up ineligible for small business set-asides.
In this context, business concerns are affiliates if 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 (regardless of whether or not the control is actually exercised). The regulations supplement this general definition with numerous more specific rules, each of which essentially shuts down a potential strategy that might otherwise be used to avoid a finding of affiliation. Under these more focused rules, affiliation may be found on the basis of: (i) stock ownership; (ii) stock options, convertible securities, and agreements to merge; (iii) common management; (iv) identity of interest; (v) participation in joint ventures; and (vi) franchise and license agreements. Affiliation may also be found where a newly organized concern is established by key employees from another company to operate in the same or related industry and the other company furnishes contracts, financial or technical assistance, or the like. Once established, a business can be held affiliated to an “ostensible subcontractor” that performs primary and vital requirements or on which the putative small business is unusually reliant. If this were not enough, the applicable regulations include a catch-all: affiliation may be found based on the totality of the circumstances even if no single regulatory factor is sufficient.
Does the Business Qualify as the Specific Type of Business You Want It to Be?
The federal government supplements its general small business set-aside opportunities with a number of more focused small business set-aside programs. While each of these programs imposes somewhat different eligibility requirements, those based the socioeconomic status of individual business owners share a common, fundamental approach: the individual(s) on whose socioeconomic status the business relies must not only have majority ownership of the business, but also effective control.
For example, a service-disabled veteran must both own and control a service disabled veteran-owned small business (SDVOSB). This means that the service disabled veteran must unconditionally own 51% of the SDVOSB, control and manage its daily operations, and hold the highest officer position in the company. Similarly, in the case of a woman-owned business, one or more women must unconditionally and directly own at least 51% of the concern and control both the long-term decision making and the day-to-day management and administration of the business operations.
Whether or not a particular business meets the eligibility requirements will depend in part on the details of how its organizing documents address the specifics of ownership and control – and other applicable set aside program rules. What may be a best practice in other contexts could render a small business ineligible for certain types of set-aside awards.
In order to effectively answer both these questions, start-up owners must identify all the applicable requirements and work to address them in the planning and drafting phase. Waiting until after the business is up and running will often require a significant investment of time and effort to modify the by-laws or operating agreement. In some cases, owners may need to dissolve their first company and start over in an attempt to achieve compliance – and in a few cases, such compliance may ultimately prove impossible. It is far better to engage an experienced attorney to help analyze and address government contracts small business issues up front.
As published in Law Week Colorado, June 19, 2017.
Eric Whytsell is responsible for the contents of this Article.
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