by Erin Andrew
One of the biggest mistakes small business owners make is planning their exit strategy too soon. Whether a contractor wants to enter, grow, or exit the market, a small business owner must understand how buying or selling their business can play a large role in their success. Below are some tips for all three phases:
Buying in the Marketplace
Past performance is critical to winning work, but many government contractors are not aware of all the tools available for small businesses to gain past performance, such as acquiring another small business.
Under FAR 15.305, an agency should consider the past performance of a predecessor company, as well as subcontractors that will play a major or critical role in a contract. An acquisition structured as a merger, with your company as the surviving entity, will trigger the predecessor company rule. Other forms of acquisitions, such as a stock purchase resulting in a parent-subsidiary relationship, may not trigger the same rule, but may still allow you to use your new affiliate as a subcontractor to leverage its past performance.
When evaluating acquisition, research and review the number of prime contracts, option years, vehicles, customers, clearances, set-asides,performance history, NAICS codes and size standards. Some things to consider when you are anticipating growth through acquisition:
- Incumbency Matters: According to a recent report, the incumbent wins the work the majority of the time. By acquiring a company and its contracts, the buyer steps assumes the incumbent position and he or she can expect to profit.
- Size and NAICS Matter: Under the Small Business Administration rules and regulations governing the North American Industry Classification System (NAICS) codes, an entity typically qualifies as small business by the number of employees over a twelve-month period or annual receipts over a three-year average–and soon to be five-year average under a bill just signed by the President (the rules are slightly different for companies that have not been in existence for the full relevant period). When a small business acquires another small firm, the number of employees/revenues are added and averaged for the relevant period determine if the firm is still small under the contract’s designated NAICS.
- Due Diligence Matters: Some contracts may have provisions that immediately prohibit performance by other buyers, unless that buyer is a small business. For example, under GSA Alliant Small Business, if a small business contract holder becomes not small after a merger or acquisition, with or without a novation agreement, the contracting officer must remove the firm from the GWAC by a no-cost termination for convenience. And, unless the SBA grants a waiver,an acquisition of an 8(a)-certified company will cause the termination for convenience of 8(a) contracts. An M&A partner can help provide due diligence and the right guidance as you move forward with a target. This due diligence will also help you ensure a fair price for the company you are acquiring based on their verifiable contract backlog.
- The Financing You use to Acquire Matters and understanding what you can buy makes a difference as you pursue targets. Leveraging programs like the SBA 7(a) loan program which has a more flexible down payment requirement and longer terms compared to a conventional transaction can help a buyer in the acquisition of another small business. The SBA loan program’s terms are 2-3 times longer than a conventional note. Understanding how these programs work and how to best leverage them plays a pivotal role in a successful transaction.
Building in the Marketplace
Every business should understand and plan for their exit strategy is regardless of where they are in their growth trajectory.
- Diversify Your Contract and Agency Profile: As your experience and relationships mature in a particular agency, winning new work will become less challenging. However, it is also important to understand how agency diversity can impact your bottom line. Based on data from the Federal Procurement Data System (FPDS), small businesses that picked up one additional agency from 2016-2017 saw a roughly $500,000 increase in obligated dollars on average. Agency diversification can guard against the risk of changes to spending priorities that can happen from year to year.
- Consider Your Size and Who Could Buy You as You Grow: It is important to understand how your size plays into your exit and that sometimes you will sell at a higher price even with lower revenues. As you determine the NAICS codes you grow into, do your best ensure that you have room to grow in the NAICS codes you work in, while remaining a small business in at least some NAICS codes. If you are working primarily in a $7M NAICS and currently have revenues at $6M, contemplate expanding your lines of work into those NAICS codes designated with $15M or $27.5M NAICS where you will have a lot of room to grow while still maintaining small business status. If someone acquires your firm as part of your long-term exit strategy, they will have room to grow as well.
- Consider an Employee Stock Ownership Program (ESOP) if You Want to Take Some Money Off the Table: An Employee Stock Ownership Plan (ESOP) is an opportunity to reward your employees for dedication to the company, get some tax benefits, and, as an owner, take some money off the table for retirement.This approach allows an owner to realize a partial value of the company without having to exit right away,therefore enabling them to continue to build the company. Additionally,government contractors with certain types of contracts who utilize an ESOP structure can reap some significant benefits. But seek legal guidance before establishing an ESOP, particularly if you’re an 8(a), SDVOSB, VOSB, or ED/WOSB company, for which nuanced ownership rules may make ESOPs more complicated to establish.
Selling in the Marketplace
As a small business approaches its exit strategy, it should examine, evaluate and reassess the strategy at least twice a year. Changes in its contracts, size, and vehicles can and do impact its ability to exit at a comfortable price. Some pointers for potential sellers include:
- Understand the Delta Between Your Desired Exit Price and the Realistic Purchase Price of Your Firm: Get a general understanding of the valuation of your company. Live Oak Bank offers free purchase price estimates to potential sellers interested in understanding the valuation of their businesses. We also pre-qualify buyers and can look at a sellers’ contracts and understand how much debt the bank could support for a buyer. Similar to real estate, whether a small business is ready to exit today or next year, it is important to understand the market rate and when is the best time for a potential exit.
- Understand the Valuation of Your Company: Valuation is more than just numbers. Live Oak Bank has former contracting officers and contracting experts who understand the value of specific contracts. We combine domain expertise along with the company’s EBITDA to determine a company’s price in the small business marketplace. This price depends on how robust margins are, the type and length of contracts, how close the company is to its size max in relevant NAICS codes and the overall financial health of the company. Set-aside status also plays a critical role for many businesses.
- The Best Time to Exit is When You Have Just Won Work: The valuation of your company takes into account the life you have left on contracts. The longer you have, the higher the price. As a result, sometimes the best time to sell is right after a big win.
Small businesses are the engine of our economy and they also fuel the important and critical work of the federal government. Understanding how your company can get in the door, have an impact and eventually put you in a position to exit is critical to your success. As you can see, it is imperative to understand the different elements of your Buy, Build, Sell strategy.
Erin Andrew joined Live Oak Bank with over 6 years at the U.S. Small Business Administration (SBA). Most recently she was Associate Administrator for Capital Access, where she oversaw the Agency’s lending efforts that included $100 billion of government loan programs for small businesses. She is also a Project Management Professional (PMP) and a Kauffman Fellow (Class 20).
Prior to her posting at SBA, Erin held positions as the Assistant Administrator for the SBA’s Office of Women’s Business Ownership where she oversaw the agency’s efforts to promote the growth of women-owned businesses. She was also Director of the Innovation Clusters and Skills Initiatives in the SBA’s office of Entrepreneurial Development where she worked to meet counseling and training needs of small businesses.
Erin holds a B.S. in business administration and ethics, and an M.S. in public policy and management, both from Carnegie Mellon University.
Erin can be reached at erin.andrew@liveoak.bank.