SBA Corrects Profit-Splitting Flaw In New Joint Venture Regulations

The SBA has corrected a flaw in the profit-splitting provisions of its new joint venture regulations.

Under the corrected regulations, which became effective on December 27, all of the SBA’s joint venture regulations–those for small businesses, SDVOSBs, HUBZones, 8(a)s, and WOSBs–will require that each joint venturer receive profits commensurate with the work it performs.  The SBA’s revisions clear up an inconsistency between the 8(a) joint venture regulations and the regulations for the SBA’s other set-aside programs, and eliminates a potential disincentive for joint venturers to avail themselves of the protections of a formal legal entity such as a limited liability company.

Effective August 2016, the SBA overhauled its joint venture regulations.  Among the major changes, the SBA eliminated so-called “populated” joint ventures and made numerous additions and revisions to the regulations governing mentor-protege joint ventures, SDVOSB joint ventures, and joint ventures for other set-aside contracts.

For those of us whose day-to-day work involves drafting joint venture agreements, it soon became apparent that the profit-sharing provisions of the new regulations were flawed.  As I wrote in an October post on SmallGovCon, the SBA’s revised 8(a) joint venture regulation stated that all joint ventures must split profits based on each joint venturer’s work share.  But for mentor-protege joint ventures pursuing small business set-aside contracts, as well as for joint ventures pursuing SDVOSB, HUBZone and WOSB contracts, the regulations stated that a “separate legal entity” joint venture (e.g., an LLC) would split profits commensurate with each party’s ownership interest in the joint venture.  In these programs, only joint ventures formed as informal partnerships would split profits based on each party’s work share.

This led to an important inconsistency: as I pointed out in my October post, in order for a “separate legal entity” 8(a) mentor-protege joint venture to receive the exception from affiliation for a small business set-aside contract, the regulations required the joint venture to split profits based on ownership and based on work share.  It wasn’t clear how the joint venture could do both.

The inconsistency in the prior regulation discouraged 8(a) mentor-protege joint venturers from establishing an LLC or other separate legal entity: by choosing an informal partnership, the joint venturers could avoid the regulatory inconsistency.  But even for other joint ventures, the regulations created a disincentive to form a separate legal entity.  By forming an informal partnership, the non-managing member could perform up to 60% of the work and receive a commensurate share of the profits.  In contrast, in an LLC or other separate legal entity, the non-managing member could still perform up to 60% of the work, but could receive no more than 49% of the profits.

In the preamble to its correction, the SBA states that “it would not make sense to require a firm to receive 51% of the profits for doing only 40% of the work.”  The SBA explains that “SBA’s intent was for profits to be commensurate with the work performed by each member of the joint venture” for all of the set-aside programs, not just the 8(a) program.  The SBA then revises the regulations governing joint ventures for small business, HUBZone, SDVOSB, and WOSB set asides to provide that the joint venture agreement must contain a provision stating that the managing member “must receive profits from the joint venture commensurate with the work performed” by the managing member.

In any major regulatory overhaul, there will inevitably be flaws of some sort.  Kudos to the SBA for recognizing the problems with its joint venture profit-splitting requirements and acting quickly to correct those flaws.