The future for successful GovCon business owners has always meant facing the existential crisis of the “size-out cliff” followed by what people in the industry have coined the “Valley of Death.” This proposed rule pushes those challenges far into the future.
This month the SBA surprised many with proposed changes to size standards for small business that caused a stir within GovCon.
The take-away everyone had was thresholds might be going up – and by lot. While it’s still early days, and these are only proposed changes, the implications for M&A – and the small business GovCon market generally — are significant.
First, let’s just look at the scale of these changes. The revenue size out for Engineering Services would move from $25.5 million to a 10x increase of $252 million. Custom Computer Programming and Computer Systems Design would go from $34 million to a 15x increase of to $531 million. Environmental Consulting would soar from $19 million to $295 million, also a 15x increase. And on and on. In fact, the SBA estimates that 114,000 companies — of which 37,000 already hold federal contracts worth more than $71 billion — not designated as small today would be able to claim that mantle. The comment period for these proposals ends September 21.
Much will be written about this rule over the next 12 months and we are early in this process. So let’s just focus how these rules will impact companies that currently have a small business designation.
The future for successful GovCon business owners has always meant facing the existential crisis of the “size-out cliff” followed by what people in the industry have coined the “Valley of Death.” This proposed rule pushes those challenges far into the future.
Today a small business can grow only so far before it loses its designation and has to compete in the “full and open” world. That transition is a substantial risk, and buyers put a price on it. A company that has never won work in the full and open market is a different asset than one that has, because nobody knows whether a small business can win new work without the help of that designation. To compensate the buyer for assuming this risk, deals include a price reduction to the Seller.
Risk to the Buyer means a lower price to the Seller. The closer a company sits to the threshold, the harder the discount bites. It is a somewhat unusual outcome. The most successful small businesses get penalized for their success until they enter the full and open market. Delaying the size out cliff makes it easier for GovCon companies to continue growing — both organically and through M&A.
These rules – if adopted — would broaden the buyer pool for small businesses. More buyers mean more competition and a better price for the Seller. Today affiliation rules aggregate the revenue of Buyer and target; after an acquisition the Buyer has to certify whether the combined entity continues to meet the set aside requirements. If not, the Seller is worth less to the Buyer and there is a price reduction. In sum, the buyer pool for a small business has effectively been limited to buyers who could satisfy the seller’s set-aside designation — a narrow universe.
The proposed rule largely removes these enterprise value limitations.
On the cliff, a threshold ten times higher pushes the crossing years out. The runway itself becomes something a buyer can underwrite rather than a risk to be discounted. On the buyer pool, affiliation and recertification still apply, so the constraint has not disappeared. But the runway for the combined Buyer and Seller is now significantly greater, so far more companies can stay under the limit. A $10 million target could be acquired by a $242 million buyer and the combination would still be small.
Companies with a small business designation may find that the market is willing to credit them with increased value – and at a minimum, remove the downward price pressure for those companies now close to sizing out.
That’s all to the good, but there are also some negative implications to these proposed rules.
First of all at a time when the number of small businesses serving the federal government is already dropping, these proposed rules could make it harder for smaller companies to compete. The reason is that suddenly they would be competing with much larger companies for work designated “small business.” For example, a $35 million company has more past performance and more certifications than a $12 million company, however these two entities have a great deal in common. But now imagine them competing with a $200 million revenue competitor. Obviously, you’ve now made it harder for the smallest firms in many NAICS codes to successfully compete.
These proposed changes – an unexpected bombshell — add uncertainty to the market.
While our GovCon ecosystem reacts and adjusts, dealmaking might slow until we have greater clarity on the future structure of this market. Business owners across government contracting need to be aware that seismic changes could be coming to a neighborhood near you.
Sharon Heaton is the CEO and Founder of sbLiftOff, a national M&A advisory that focuses on government contracting. A national advocate for small business founders her commentary can be found in Harvard Business Review, Orange Slices, Washington Business, and beyond.