Key Details: Mergers & acquisitions (M&A) involving federal contractors have surged recently as buyers and investors shift their focus to the lucrative contracting marketplace. Increasing valuations and deal volumes have also caused government contractors to consider the M&A route to expand their business. However, buyers and sellers must consider additional legal and financial due diligence items in a highly regulated industry to avoid potential pitfalls. In addition to traditional due diligence considerations such as quality of earnings and tax compliance, transactions involving government contractors must also look towards regulatory and other compliance-related topics. Understanding additional considerations within this unique environment will aid in a smooth transaction.
The following article highlights key considerations for buyers and sellers to understand when structuring a gov con M&A deal. Part one of this four-part series explores contract novation and recertification considerations. Part two analyzes contract types, accounting system compliance, and timekeeping compliance. Part three will dive into incurred cost submissions, budgets, contract compliance, performance risk, and contractor purchasing systems. Finally, part four analyzes changes in ownership considerations, representations and warranties, security clearances, and the False Claims Act.
It is important to note that the topics discussed are for educational purposes and should not be taken as legal advice. Potential buyers and sellers are encouraged to consult legal counsel when structuring an M&A deal. The topics below are not all-inclusive, and additional considerations may be discussed with an advisor.
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Novation Considerations
M&A transactions involving government contractors generally require a unique novation process due to the limits under the Anti-Assignment Act (41 U.S.C. § 6305). The Anti-Assignment Act limits a contractor's right to assign a contract or a right of payment under the contract to a third party. As such, the Anti-Assignment Act prohibits the transfer of a government contract to a third party and provides novation procedures to avoid potential violations.
A novation allows the Government to recognize a new contractor as a successor to a government contract. It creates a three-party agreement between the U.S., the transferor, and the transferee. The novation agreement requires the transferee to agree to be bound by all obligations and liabilities of the transferor and the transferor to waive all claims and rights against the Government in connection with the novated contracts.
Businesses are encouraged to begin the novation process early to avoid potential pitfalls. However, it is essential to note that the novation will not be finalized until the transaction is complete.
Transaction Types that Require Novation
Certain types of M&A transactions do not trigger the Anti-Assignment Act and do not require a novation. This typically applies to stock purchases without legal change in the contracting party. Under this scenario, the contracting party continues performance on the contract and maintains control of assets for contract performance. However, businesses undergoing the transaction process are encouraged to speak with legal counsel to ensure a novation is not required.
Asset purchases generally require novation as a third party acquires the assets involved in the performance of a contract. Additionally, contract performance will then be conducted by a separate legal entity.
Many contracts contain changes in control provisions, regardless of the type of transaction. This provision in an agreement gives a party certain right (such as consent, payment, or termination) if there is a change in ownership or management of the second party in the agreement. It is important to note that not all provisions are triggered by the same actions. As such, it is essential to speak with legal counsel to determine if a change in control provision will be triggered. This is also applicable to businesses with subcontracts. Both parties are encouraged to review subcontract and related documents for change in control provisions.
The Novation Process
Federal Acquisition Regulation (FAR) 42.1204 Applicability of Novation Agreements provides the standard form Novation Agreement businesses must use and the required documents to be submitted with the novation package. Businesses are encouraged to begin the novation process early and to ensure necessary documents are gathered to streamline the process. Additionally, businesses are encouraged to perform the following actions to navigate this complex process:
- Examine existing contracts for clauses that may restrict a novation.
- Meet with legal counsel and the transferee to draft a novation agreement.
- Notify third parties that may be impacted, such as suppliers and lenders.
- Ensure all other required documentation (as outlined in FAR 42.1204) is gathered and retained securely.
- Once the transaction is complete, submit the novation package for approval.
Size Standards and Recertification Considerations
Within the government contracting marketplace, size standards define the largest size a business can be to participate in a particular government contracting program or to compete for specific set-aside contracts. Each industry has different size standards based on employee count or annual receipts. Small business size standards and regulations are within Title 13 Part 121 of the Electronic Code of Federal Regulations. The SBA also provides the latest size standards here.
M&A transactions involving government contractors who qualify as small businesses or hold a socio-economic status present additional challenges for potential buyers. As such, it is crucial to consider various recertification regulations, affiliation rules, and size certifications as the transaction proceeds. Additionally, businesses should note that size status is not a static metric and can change over time due to growth or reductions.
Recertification Regulations
Under the Small Business Administration (SBA) regulations, contractors must generally recertify their size status within 30 days of a novated contract. This recertification process provides the Government with verification that businesses are eligible to perform on certain types of contracts or to participate in specific programs. Size certification is typically based on the business's status when the bid is submitted to the Government. Subsequent recertification is generally not a requirement unless specific scenarios occur. Businesses certified as small businesses holding a long-term contract of more than five years must recertify their size status. Additionally, as noted above, contracts that the Government novates require recertification within 30 days of the approved novation.
Businesses should also note that recertification is generally required after an M&A transaction with a change in controlling interest and no contract novation. This applies to pending proposals and bids as the SBA considers control changes as factors that may impact eligibility. As such, businesses are encouraged to consider potential roadblocks in the recertification process as part of negotiations and to retain legal counsel to ensure that preliminary agreements address recertification procedures.
Affiliation
Government contracting businesses should also consider the importance of SBA affiliation rules as they move through the M&A process. Acquirers considering a small business or a target who has set aside contracts should understand how subsequent affiliation or its size would impact the acquirer's size. This applies to current affiliates, the target, and potential post-closing affiliates.
Size standards are based on the six-digit North American Industrial Classification System (NAICS) code. Under SBA affiliation rules, if one company owns more than 50% of another, they are considered affiliated. As such, traditional M&A transactions will trigger affiliation rules if the acquirer gains too much control over the acquired company. Potential buyers are encouraged to determine early if a transaction would impact or trigger the affiliation rule and how the company's contracts may be affected.
Conclusion
As discussed above, M&A transactions involving government contractors bring additional considerations that must be investigated and analyzed pre- and post-deal. Buyers should be aware of the unique topics that should be examined during the due diligence process and begin the process early to lower any transaction or business risk. Understanding these unique considerations and speaking with an advisor will ensure a smooth transaction process. Businesses are also encouraged to review the following action items to get started:
- Identify all current and future contracts the target is performing or bidding on to begin the novation process early. This should include an analysis of the seller's pipeline.
- Speak with legal counsel to determine contracts that require novation.
- Gather the necessary materials and documentation to create the novation package.
- Notify third parties that may be impacted, such as suppliers and lenders.
- Review if the target company is a certified small business participating in a set-aside program.
- Understand if affiliation rules will be triggered post-acquisition and begin implementing a recertification plan to stay ahead.
- Create a contract matrix to understand the regulations applicable to each current and future contract.
- Many purchase agreements include a 338(h)(10) provision, which is an asset sale for tax purposes, but a legal stock sale. Analyze the potential pros and cons associated with this election and how this may impact contract novation considerations.
Readers should discuss these items with legal counsel before implementing any strategies, as each deal has unique characteristics.
For more information and expertise, contact Ryan & Wetmore.
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About Peter Ryan
Partner, Co-founder, & CPA
Peter T. Ryan co-founded Ryan & Wetmore in 1988 with business partner Michael J. Wetmore. Peter provides clients with the best strategies for success. His expertise extends across various industries. Peter obtained a Master of Business Administration in Finance from the University of Baltimore and a Bachelor of Arts in Accounting from the Catholic University of America.
About Rosie Cheng
Finance Consultant
Rosie Cheng is a Finance Consultant at Ryan & Wetmore. She focuses on government contracting services and produces many of the firm’s government contracting newsletters. Rosie graduated from Georgetown University with a Master of Science in Management and from William and Mary with a Bachelor of Business Administration.