Small Business Affiliation

As I have covered here before, every small business owner needs to be aware of the Small Business Administration’s (SBA) ostensible subcontractor rule.

In a nutshell, ostensible contractor affiliation occurs when a small business holds a prime contract – but a subcontractor hired for the job actually ends up controlling the work.  The SBA targets instances where the subcontractor (and not the small business prime) performs the “primary and vital” work of the contract.  Affiliation can also arise under the ostensible subcontractor rule if the small business is “unusually reliant” on its subcontractor.

The typical ostensible subcontractor rule violation involves a small business (prime contractor) and a large business (subcontractor).  For example, if the small business lacks the needed resources or expertise, it can find itself leaning on its large subcontractor to run the project to too great of an extent.  Anytime the large sub takes over a primary role on the project, there is danger of ostensible contractor affiliation.

However, in a recent decision, the SBA’s Office of Hearings and Appeals (OHA) drew out an important distinction in the law.  While the small prime/large sub relationship is more common, the ostensible subcontractor rule remains firmly in play even as between two small businesses.

The OHA decision arises out of a size protest filed in connection with a health services contract offered by the Florida Army National Guard.  After the SBA Area Office found the contract awardee small for purposes of the contract, the protester appealed and argued that the Area Office improperly failed to consider whether the awardee was affiliated with its proposed subcontractor under the ostensible subcontractor rule.

The Area Office based its decision on the size of the proposed contractor/subcontractor team.  Specifically, the Area Office reasoned that – because both firms were small for the purposes of the procurement – even if they formed a joint venture, affiliation by the ostensible subcontractor rule would not be found.  According to the Area Office, the SBA’s regulations intend for joint ventures to be treated as small as long as each of the joint venture members is small, without regard to the ostensible subcontractor rule.

On appeal, OHA disagreed with the Area Office.  OHA pointed out that the ostensible subcontractor rule does not include any exceptions for joint ventures where both members are small. To the contrary, the rule requires SBA to evaluate whether the firms are ostensible subcontractors; if they are, they will be considered joint venturers and affiliated for the purposes of a size determination.

OHA found that it could not accept Area Office’s conclusion that there had been no violation of the ostensible subcontractor rule because it never performed the required analysis.  Accordingly, OHA granted the appeal and ordered the Area Office to make a new size determination, including an examination of whether the participating firms were affiliated under the ostensible subcontractor rule.

 

Today, we take a look at the culmination of a long fight over the size status of a joint venture competing for a Federal contract.  After losing battles at the Small Business Administration (SBA) Area Office and Office of Hearings and Appeals (OHA) – the joint venture finally won the war when the Court of Federal Claims (COFC) declared that SBA incorrectly applied the economic dependence test.

quick refresher on SBA economic dependence:  In a nutshell, the SBA will find two firms affiliated through economic dependence when a small business is dependent on another company for a disproportionate amount of its revenue.  Without a steady flow of business from its counterpart, the small business would be unable to survive (let alone thrive).  When one business is economically dependent on another, there is a presumption of affiliation.

That was precisely SBA’s finding with respect to the joint venture that teamed up to bid on a Department of Defense Missile Defense Agency support contract.  The SBA Area Office found the joint venture was “other than small” for purposes of the contract (and, therefore, ineligible for award).  OHA agreed, confirming that one of the joint venture partners was affiliated with a third entity (and therefore had to include that entity’s average annual receipts in its size calculation).  As a result of this affiliation, the joint venture partner was deemed to be a large business under the relevant size standard, thus disqualifying the joint venture.

Specifically, SBA found the two firms affiliated because the purported small business received more than 70% of its revenue from the third firm, thus creating an “identity of interest due to economic dependency.”  According to OHA’s decision, “as a matter of law, a firm that derives 70 percent or more of its revenue from another firm is economically dependent on that firm.”

On appeal to COFC, the joint venture argued that SBA misapplied the presumption of economic independence as a bright line rule – as opposed to a rebuttable presumption.  Here, the mitigating factors weighing against affiliation included the fact that the small firm had only been operating a short time and held a small number of contracts (which distorted the 70% figure relied on by OHA).  The joint venture also presented evidence of the firm’s attempts to diversify and expand to other sources of revenue.

The COFC was persuaded by these arguments and remanded size determination back to the Area Office for a new review.  In its decision, the court affirmed that the 70% standard  is highly indicative of economic dependence – but still not an absolute rule.  COFC determined that OHA failed to consider properly the mitigating factors presented.

This is a fascinating case study and a great example of a firm forcing SBA to faithfully apply its own regulations.  But – importantly – it also needs to be taken with a grain of salt and viewed as the exception to the rule.

The fact remains that there is a rock solid basis to support the SBA’s use of the 70% threshold as a standard for finding affiliation based on economic dependence – both in the regulations and in the case law.  If your business receives even close to 70% of its receipts from one business – there is a definite cause for concern.  This case confirms that your business has the ability to try and rebut the presumption of affiliation – but that can be a steep mountain to climb.

If you are concerned about your firm losing its size standard due to economic dependence – now is the time to think about proactive strategies for diversifying.  Relying on a winning rebuttal argument with the SBA is betting against the house.

Join me on Thursday, August 24, 2017 for lunch (11:30 am to 1:30 pm) and learn about the Small Business Administration’s All Small Mentor Protégé Program. The event is sponsored by Design-Build Institute of American Mid-Atlantic and will be held at Maggiano’s in Tysons Corner.

For months, we poured over the proposed and final rules – speculating about how the Program would look and operate.  Now it is here.  With the SBA accepting and processing applications at a healthy clip, there is no better time than the present to get up to speed.

During the event, we will walk through the basics of the All-Small Program, including the application and approval process.  We will also talk about big picture issues, including the Program’s general shield against affiliation and the most important questions for contractors (both large and small) considering taking the leap.

The event will also offer insights for contractors that have already investigated the Program.  For example, we will discuss the newly published requirements for mentor-protégé agreements and joint venture agreements formed between Program participants.  Careful consideration of the issues captured in these agreements can make the difference between a successful partnership . . . and the undesirable alternatives.

I hope that you can join us on the 24th.  I am happy to chat after the presentation about any specific questions facing your business.  If you can’t make the event, you can always contact me here to discuss your questions.

Government contractors looking to identify and mitigate indications of affiliation sometimes need look no further than their own family tree.

The Small Business Administration (SBA) assumes that two businesses owned and controlled by members of the same family are affiliated based on that family relationship alone.  It is up to the family members to rebut the presumption.

The SBA’s Office of Hearings and Appeals (OHA) reaffirmed this “Familial Identity of Interest” standard in spades in a recent decision.  OHA found two businesses affiliated based on the ownership and control of two brothers.  To be clear, the brothers did not co-own the businesses – each brother owned and controlled his own business.

The OHA decision is significant because it reaffirms the presumption of affiliation in such cases.  The businesses argued that they should not be considered affiliated because there is no evidence that either brother could control the other’s business.  OHA rejected this argument as immaterial.  There is no need for a finding of affirmative control when it comes to family relationships – the relationship alone is sufficient to create a presumption of identical interests.

So how do family members rebut the presumption of affiliation?

There are two generally recognized ways.  The first is to show that the family members are estranged.  Family members that are not in contact with each other are not presumed to share identical interests.  Obviously, this is a subjective question that will require at least some actual evidence to support the claim.

The second way to rebut the familial identity of interest is to show that there is no – or at least very little – involvement between the family businesses.  In the case under review here, the brothers shared some fairly significant overlap in their businesses, including ownership interests, contracts/subcontracts, and a common NAICS code.  OHA concluded that these shared interests went beyond the minimal contacts allowed in earlier decisions.

The bottom line:  Government contractors with close family members that own a business – particularly a business in the same general field on industry – need to proceed with caution.  The best practice is to conduct zero business between the two entities and document affirmative efforts to wall off any actual or perceived shared interest.  Even a small amount of interaction can start to tip the scale towards a finding of affiliation.

Contractors seeking to avoid affiliation under the Ostensible Subcontractor Rule know the soundbite:  Your firm must self-perform the “primary and vital” contract requirements.

A small business prime contractor must zero in on the essential objective of its contract and make sure to perform those requirements with its own employees.  If those requirements are subcontracted out to others, the SBA will have all the ammunition it needs to find affiliation.

While the “primary and vital” requirements test is the most commonly cited metric for the Ostensible Subcontractor Rule, a recent Small Business Administration Office of Hearings & Appeals decision reminds us that there is another factor to consider.  Namely, affiliation can also arise under the Ostensible Subcontractor if the small business prime contractor is unusually reliant on its subcontractor.

The SBA considered a General Services Administration custodial, landscaping, and grounds maintenance services contract set aside for small businesses.  On the facts presented in the appeal, it appears that the small business prime contractor would meet the requirement to perform the contract’s primary and vital requirements by, among other things, providing custodial services and controlling all contract management activities

Digging deeper, however, the SBA determined that the primary and vital issue was irrelevant to the final analysis.

According to the SBA, the Ostensible Subcontractor Rule is “disjunctive” – which is to say that the contractor must perform the primary and vital requirements AND cannot be unduly reliant on its subcontractor.  The inquiries are totally independent and a black mark on either is enough to tip the scales towards affiliation.

So, getting back to the appeal, the SBA looked at the small business’s relationship with its subcontractor and found a textbook example of over-reliance:

  • The subcontractor was the incumbent contractor on the project, but ineligible to submit its own proposal on the restricted set-aside contract
  • The small business prime planned to staff its part of the contract almost entirely with the subcontractor’s former employees
  • The proposed project manager previously served with the subcontractor on the incumbent contract, and
  • The small business prime lacked its own experience and needed the subcontractor to successfully perform (including a stated intent to sub-out 49% percent of the work to one entity)

Cumulatively, these factors were enough for the SBA to find affiliation based on the Ostensible Subcontractor Rule (and, specifically, the prohibition against undue reliance).  No further inquiry into performance of the primary and vital requirements was necessary.

Small business owners must always be mindful of what it means to be “small” in the world of government contracting.  After all, losing that small business size status means losing direct access to the lucrative world of set-aside contracts and the SBA’s socio-economic programs.

In the past, we’ve discussed the SBA’s rules on affiliation – in short, the rules that determine whether you actually own and control your small business.  A finding of affiliation between two companies means that the firms are viewed by the SBA as a single entity for purposes of determining size.  Even a very small business can lose its size status if it is affiliated with another company (or multiple companies) that push it over the size threshold.

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In addition to paying attention to active connections that could lead to a finding of affiliation, a recent SBA opinion reminds us that small business owners also need to avoid ostensible contractor affiliation (a current hot topic at the SBA and the reason behind many affiliation determinations).

In a nutshell, ostensible contractor affiliation occurs when a small business holds a prime contract – but a subcontractor hired for the job actually ends up controlling the work.  Specifically, the SBA targets instances where the subcontractor (and not the small business prime) performs the primary and vital work of the contract.  Affiliation can also arise under the ostensible subcontractor rule if the small business is unusually reliant on its subcontractor.

Take, for example, the SBA’s recent holding.  A small business was awarded an Army contract for waste management services.  In its proposal, the small business committed to performing all contract management services, including operations, customer service, and billing.  However, it subcontracted out to another business the work of diversion, disposal, and management of solid waste.  The SBA determined those waste management services to be the essential requirements of the contract and, therefore, found affiliation under the ostensible contractor rule.

As in all cases of affiliation, the finding had damaging effects, as the original contract awardee now exceeded the size standard of a small business and lost the contract.

This case should lead us to a practical question:  How do I avoid becoming affiliated under the ostensible subcontractor rule?  Fortunately, there are quite a lot of steps that you can take:

  • Focus on the kinds of work and the percentage of prime contractor performance.  In our sample case, it is not too controversial to suggest that waste management services are “primary and vital” to a waste management contract.  However, for other contracts, the essential work that should be performed by the small business prime contractor might not be as obvious.  In all cases, take the time in advance to think about the primary services being performed and whether the prime contractor is performing a reasonable percentage of that work (in addition to the required percentage of self-performance under the SBA’s limitation on subcontracting).  If the subcontractor is performing most or all of the heavy lifting, it is a warning that you might have an ostensible subcontractor problem.
  • Preparation, Preparation, Preparation.  From the outset, your proposal should give the appearance that the small business prime contractor is in control – even if it is already working with a proposed subcontractor.  Adhering to traditional prime and subcontractor roles (rather than approaching from the position of a partnership) can enhance the appearance that the small business is controlling the essential work of the contract.
  • Show Them the Money.  One of the hallmarks of ostensible contractor relationships is profit sharing.  Any non-traditional method of payment will suggest a lack of control to the SBA.  If you hold a prime contract and affiliation is a concern, you should pay your subcontractors like traditional subs.

Like so many issues when it comes to the SBA and affiliation, the ostensible contractor rule exists on a sliding scale.  There is no cure-all for avoiding affiliation, and the SBA will look to multiple factors in weighing the “totality of the circumstances.”

With that in mind, affiliation should always be at the top of your list.  Once a proposal is submitted, it is very difficult to un-tangle the prime and sub relationship.  The focus should be on preparing a proposal that places the small business prime firmly in control and includes proactive measures to ensure sufficient performance of the primary and vital work for the contract.

Under the Small Business Administration’s regulations, two firms may partner as a joint venture to perform a small business set-aside contract, provided that each partner is a small business under the size standard assigned to the contract.  But, a recent SBA decision highlights the fact that simply entering into a joint venture does not excuse each member of the joint venture from SBA scrutiny over affiliation.

In this recent case, a U.S. Department of Defense, Missile Defense Agency contract for business operations support was awarded to a joint venture composed of two (allegedly) small businesses.  Following a size protest, the SBA took a closer look at each member of the JV and didn’t like what it found.

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While one of the JV partners was in fact small, the other had a problem.  Specifically, citing to the economic dependence rule, the SBA found that the second firm derived more than 70% (and, in fact, close to 100%) of its business from one source (a large business) over a three year period.  Based on this dependence, the SBA determined that the firms are affiliated.

This is bad news not only for the (now no longer small) firm, but also the JV itself.  Because each member of the JV is not small, the SBA determined that the JV is not small for purposes of this procurement.  In other words, the JV lost the contract.

This case highlights two important points.  First, it is essential for small businesses to understand the SBA’s rules on affiliation and be confident in their size.  Size protests unfold quickly, so information about your business’s size should be at your fingertips — and nothing should come as a surprise.  Second, the case reinforces the importance of smart teaming on government contracts.  If you pick the wrong dance partner, you could find your time and effort in pursuing (and even winning) a contract award is ultimately wasted.

If you are interested, you can learn a lot more about smart and strategic teaming in this presentation.

For small business government contractors, the question of affiliation should always be at the top of the list of priorities.  A finding of affiliation between your business and another business (and, in particular, a large business) could be enough to lose your small business size status – and the ability to compete for those coveted set-aside contracts.

One of the few recognized exceptions to affiliation is an approved mentor-protégé relationship under the Small Business Administration’s (SBA) 8(a) business development program.  In short, an 8(a) protégé can joint venture with its SBA-approved large business mentor and still qualify as a small business for any federal government contract or subcontract – without the fear of affiliation.

While it may seem a bit obvious or a simple matter of housekeeping, the SBA’s Office of Hearing and Appeals recently issued a stern warning that the exception to affiliation depends of having an approved mentor-protégé agreement in place.  Specifically, OHA concluded that failure to obtain the proper documentation resulted in a finding of affiliation and precluded eligibility for a small business set-aside contract — even when the two firms involved had a long history of participation in the mentor-protégé program.

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This decision serves as an important reminder for firms currently partnering as part of the 8(a) program to stay current – but it should also be a wake-up call for all of the businesses out there planning to take advantage of the SBA’s imminent (groundbreaking) expansion of the mentor-protégé program.

Now that the SBA is accepting expanded mentor-protégé program applications, it is a great time to take stock of how to make the program work for your business.  As we recently highlighted, partnering between government contractors can open the door to new and exciting opportunities – but it works best for those firms that conduct proper due diligence.

Is your mentor-protégé agreement working for you?  Now is the time to find out and (if necessary) make the appropriate course corrections.

The SBA’s new “small business mentor-protégé program” is causing quite a stir.  As we covered yesterday, the new final rule opens the door for all small businesses (not just those in the 8(a) program) to receive assistance from large business mentors – and more importantly – to form mentor-protégé joint ventures to compete for small business set-aside contracts (including those offered under the SBA’s socioeconomic programs, such as WOSB, SDVOSB, and HUBZone) without the danger of affiliation.

This new program is a game-changer for small business owners.  Now, instead of competing for set-aside work against fellow small businesses, you might find yourself up against a JV backed by the might of a large business.  The result is an uneven playing field where a “true” small business is up against a stacked deck.  There is also a paradigm shift for large business owners, as the SBA is now offering unprecedented access to set-aside contracts previously reserved for performance by only small businesses.

The first instinct for many will be to rush out and find a dance partner.  That is, another business —  large or small, as the case may be — to team with so that you’ll be on even footing when competing for those small business set-aside contracts.

But is a teaming arrangement right for your business?  We suggest thinking strategically and looking before you leap.

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Long before the SBA announced its new program, teaming arrangements presented an avenue for businesses (and, in particular, large and small teammates) to uncover new contracting opportunities.  But just because you can get new work through teaming doesn’t necessarily mean that you should.

Before jumping into a new project delivery team, Federal contractors (both large and small) should consider intangibles like chemistry, communication, and cooperation.  Teaming with a business that does not share your corporate values, risk tolerance, or project management approach will undoubtedly negatively affect project performance – and, eventually, your bottom line.

For example, in order to participate in the new SBA program, the parties must submit a written Mentor-Protégé Agreement for review and approval by the SBA.  The Agreement should address the small business protégé’s needs, as well as when and how the large business mentor will address those needs.

This Agreement should not be hastily pulled together to make sure that your new JV is first-in-line when the program opens for business next month.  Instead, we recommend a thoughtful process that considers the wants-and-needs of both the large and small teammate.  A solid foundation will make sure both sides start off on the right foot and have a clear picture of how the relationship will unfold (and hopefully continue).

If you are interested in learning more about successful Federal project delivery teaming, I recommend taking a look at the slides from my recent presentation on the subject.  They may help you find the right path if you are considering jumping into the new mentor-protégé pool.

The future is now for government contractors.  A new Small Business Administration (SBA) regulation finalizes the long-anticipated expansion of the small business mentor-protégé program.  This major policy shift vastly expands access to set-aside contracts previously reserved for performance only by small businesses.  Government contractors – both small and large – need to create a game plan for how to take advantage of this shifting landscape.

At the heart of the new program is the SBA’s decision to allow small business protégés to joint venture with large business mentors to compete for federal work — all without worrying about affiliation.  These new mentor-protégé joint ventures can compete for any federal work — including small business set-aside contracts — provided only that the protégé qualifies as small for the procurement.  In the rule, the SBA specifically provides that no determination of affiliation or control can be based solely on the mentor-protégé agreement, or any assistance provided by the mentor under that agreement

Previously, this shield from affiliation was reserved only for the 8(a) program.  Now, all small businesses (including participants in the HubZone, Women-Owned Small Business (WOSB and EDWOSB), and Service-Disabled Veteran Owned Small Business programs (SDVOSB)) will have the opportunity to form SBA approved mentor-protégé teams with larger businesses.  By entering into a new mentor-protégé team, these joint ventures can compete for and win small business set-aside contracts (including contracts offered under the SBA’s socio-economic programs).

The SBA’s final rule sets out all of the particulars of the new small business mentor-protégé program, including:

  • How a business can qualify as a mentor or protégé
  • The requirements for a written Mentor-Protégé Agreement, and
  • How the SBA will process what is expected to be a flood of new program applications.

The rule becomes effective in 30 days (August 24, 2016) – so now is the time to figure out where your business stands, find a mentor or protégé, and start the application process.

While there is much left to be sorted out in terms of how the rule translates from on-paper to in-practice, we anticipate that small businesses (including SDVOSBs, HUBZones, and WOSBs) will face heavily increased competition on set-aside contracts from peers now backed by the support and assistance of a large business.

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Is your business ready to tackle these new challenges?