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 process as they look 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 some 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. Additionally, the topics below are not all-inclusive, and additional considerations may be discussed with an advisor.
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Incurred Cost Submissions
Buyers must be aware of the potential requirement for an incurred cost proposal, as this will directly affect the target's billing, indirect rates, and overall compliance with regulatory requirements. Incurred cost proposals (also known as an ICE Model or Incurred Cost Submission) are required if a contractor performs on a cost-plus or T&M (in some cases) contract. Under these contract types, billings throughout the year for costs incurred used either provisional or estimated indirect rates. The incurred cost proposals trues up the billings throughout the year to the actual indirect cost rate. As such, under or over-billings will be created, and additional funding or refunds will be required. Buyers should request previously incurred cost submissions (if applicable) and inquire if the target is undergoing an audit. Additionally, buyers should note that the incurred cost proposal is due within 6 months of the fiscal year-end. This needs to be accounted for during the transaction process to ensure deadlines are met.
Review of Budgets and Forecasts
Reviewing budgets, forecasts, pipelines, backlogs, and projected sales reports during the due diligence process is of paramount importance for both the buyer and the seller. Through the development of these reports, the seller can showcase a clear understanding of its target market, customers, and sales process to grow their business. Buyers should also analyze both previous and current forecasts to assess financial viability. This analysis should include the following activities:
- Identify who prepared the projects, the process used (such as top-down or bottom-up), and the functional purpose of the projection.
- Conduct an analytical review of historical data and investigate past trends or patterns that drive revenues, expenses, and overall company trajectory.
- Analyze the target company’s current financial position to detect any abnormalities or trends that reaffirm historical patterns.
- Examine key financial ratios (such as profitability margins and liquidity ratios) against industry benchmarks.
- Assess the variance between historical projections and actual financial data to identify areas where the projection was not accurate. Investigate the probability of variances occurring in current projections.
- Review the target company’s pipeline and backlog. Within this, assess:
- The total contract value of all current contracts.
- The total funded value of current contracts. Identify if there are any contracts that are nearing the end of the performance period but have insufficient funding remaining.
- The total revenue from contract inception to date. Analyze if the total revenue received or billed is greater than the contract or funded value and inquire about the target company if so.
- The total unfunded backlog amount. Discuss with the target company if they anticipate approval of future funding.
- The target company's anticipated pipeline, including the probability of winning future contracts. Discuss the basis for these estimates with the company.
Sellers are also encouraged to utilize the following steps to ensure their forecasting method is complete, accurate, and reasonable:
- Ensure the purpose of the forecast is clearly defined so all key stakeholders are aware of the various metrics and factors that need to be analyzed.
- Gather historical financial statements and data that are relevant to the forecast.
- Choose the time frame of the forecast and the financial forecast method.
- Discuss future contract prospects with the business development team and the probability of the company attaining the contract.
- Meet with project leaders to assess current contract funding and potential future funded amounts.
Contract Compliance
During the due diligence process, buyers must examine and analyze the target company's contract compliance and adherence to various contractual obligations to mitigate potential risks. This analysis involves several key components, such as reviewing options years to understand contract extension opportunities, examining contract agreements with contracting officers to evaluate performance incentives and pricing structures, and assessing compliance with contract clauses to ensure adherence to regulatory requirements. Additionally, understanding termination and renewal provisions and contract milestones is crucial for identifying potential liabilities and opportunities. By conducting a comprehensive contract compliance review, buyers can gain valuable insights into the target company's contract management practices and make informed decisions regarding the transaction.
Review Option Years
Buyers should identify and request all existing contracts held by the target company and determine if any of these contracts include option years. Option years are additional periods beyond the initial contract term that the government or contracting agency may choose to exercise. Additionally, buyers are encouraged to meet with legal counsel to review the terms and conditions of each contract and the criteria for exercising option years, such as performance evaluations, price adjustments, or notice adjustments. Assessment of the target company's historical performance in exercising options years, including any instances of failure to meet contractual requirements, should also be conducted.
Review Contract Agreements with Contracting Officers
Buyers should request copies of contract agreements between the target company and contracting officers, including any modifications or amendments. An assessment and analysis of the work performance and any bonuses for the level of effort should be conducted if applicable. The buyer should evaluate the target company's compliance with these terms, including any bonuses earned or penalties incurred due to non-compliance.
Review Price Escalation Clauses and Compare with Direct Labor Rates
Any clauses related to price escalation within current contracts and associated modifications should be analyzed with legal counsel. These price escalation clauses generally allow for adjustments to contract pricing and funding based on specified factors such as inflation or changes in labor rates. As such, the terms of these clauses should be examined alongside the impact on contract pricing over time, including any limitations or conditions for invoking price adjustments. Additionally, the target company’s direct labor rates and associated escalation should be compared to the escalation clauses within contracts to ensure consistency and compliance with contractual obligations, taking into account applicable wage determinations or prevailing wage rates.
Review Contract Renewal Timing
A timeline for contract renewal bidding should be established by the target company to ensure it is aligned with the buyer’s expectations. This should include expiration dates of existing contracts held by the target company. Identification of renewal dates for each contract and associated deadlines or milestones for initiating the renewal process should also be summarized by the target company within a grid. Buyers should also assess the target company’s readiness and strategy for bidding on contract renewals, including analysis of historical successes or failures in securing contract extensions or recompetes. Buyers must consider the potential impact of contract renewals on the target company’s forecasted revenue streams, competitive positioning, and long-term growth prospects.
Review Compliance with Contract Clauses
Buyers should aim to conduct a thorough review of all contract clauses during the due diligence process to identify compliance requirements. This should include requirements related to performance, reporting, quality assurance, and subcontracting goals and plans. The target company's adherence to these clauses should be evaluated, including instances of non-compliance or where contractual violations were identified through internal audits, government audits, or other feedback. As such, the potential impact of non-compliance on future contract awards and performance should be assessed.
Within this review of contract clauses, buyers should investigate the termination and renewal provisions outlined in each contract, including any clauses related to termination for convenience or default. The conditions and procedures for terminating and renewing contracts should be investigated to understand any notice requirements, cure periods, or termination fees and penalties. Significant milestones should also be identified and reviewed to ensure various deliverables or reporting requirements are met post-transaction.
Performance Risk
Buyers should evaluate the performance risk associated with an acquisition or merger with a government contracting business. It is imperative to assess various factors to ensure successful contract transitions and executions post-transaction and to mitigate potential risks and challenges. Understanding the requirements outlined in the statement of work (SOW) is crucial and involves a comprehensive analysis of the scope, deliverables, and performance expectations set forth by the Government. Additionally, buyers should assess the target company's capacity to meet the Government's timeline by understanding their operational capabilities, resource availability, and project management proficiency. Moreover, identifying any uncertainties within the contract terms or SOW is vital and may entail seeking additional clarification from the contracting officer or government representatives to mitigate ambiguity and ensure alignment with contractual obligations.
Buyers should also examine the target company's past performance and identify where subcontractors or consultants with the requisite expertise might be required to mitigate performance risk. Additionally, buyers should consider implementing control mechanisms post-transaction to handle any increased work or "scope creep." This could include implementing a robust project management system, allocating resources effectively, or creating contingency plans to address unforeseen challenges or scope changes. Additionally, potential "rate creep" should be assessed to determine if contract escalation clauses are sufficient to cover wage inflation.
Contractor Purchasing Systems
As part of the M&A process involving a government contractor, it is imperative to analyze FAR Subpart 44.3, which outlines the contractor's purchasing system reviews (CPSR). These reviews serve a critical role, aiming to assess not just the financial efficiency but also the adherence to governmental policies in subcontracting practices. The CPSR is used to evaluate how effectively contractors use government funds and provides administrative contracting officers (ACOs) with insights into the contractor's purchasing system. This allows them to make informed decisions regarding the approval or withdrawal of such systems. Buyers should request information regarding any past CPSRs completed and the results of the evaluation. A review of the contractor's purchasing system may provide valuable insights into the efficiency and effectiveness of the utilization of government funds and compliance with applicable regulations.
Conclusion
As discussed above, M&A transactions involving government contractors bring about 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:
- Review compliance with the incurred cost proposal process and request past audits if applicable.
- Ensure that the target company’s forecasts are aligned with your expectations.
- Conduct an analytical review of historical data and investigate past trends or patterns that drive revenues, expenses, and overall company trajectory.
- Analyze the target company’s current financial position to detect any abnormalities or trends that reaffirm historical patterns.
- Review the target company’s funding and adequacy of future funding and contract opportunities.
- Request a contract matrix that contains a current, complete, and accurate list of each government contract that includes the contract name and number, customer, award date, period of performance, contract type, contract amount and revenue, as well as any other set-aside or reserved basis. This will enable both parties to identify all contracts that will impact on the transaction.
Readers should discuss these items with legal counsel before implementing any strategies, as each deal has unique characteristics.
For further information and expertise, contact Ryan & Wetmore today.
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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.