The House and Senate have passed the “Small Business Runway Extension Act of 2018,” which appears poised to become law in the coming days. As my colleague Matt Moriarty has written, the bill would amend the SBA’s small business size rules to use a five-year average, instead of a three-year average, in calculations using receipts-based size standards.
The purpose of the bill is to help contractors avoid becoming “other than small” following a period of quick growth, but not all companies will benefit. For companies with declining revenues, the bill may backfire, causing those companies to be stuck as large businesses longer.
Under the Small Business Act and SBA’s corresponding regulations, size in receipts-based NAICS codes has long been based on a three-year average (except for newer companies, which essentially use a pro rated formula). If a company grows quickly, it can soon “size out” of relevant size standards. By the same token, if a large company’s receipts decline, it eventually can “roll out” higher-earning years, recapturing small business status.
The new five-year formula undoubtedly will help many growing companies, but seems likely to backfire on some companies with declining revenues. A five-year period will force some of these companies to continue self-certifying as large considerably longer.
Examples are fun, right? So let’s look at a couple examples of how the five-year period can both help and hurt. In each example, we’ll use NAICS code 541310 (Architectural Services), with a corresponding $7.5 million size standard, but the principles would apply to any receipts-based NAICS size standard. We’ll assume that size is being determined in 2019, with the company’s 2018 fiscal year being the most recently completed.
Example #1 – Growing Small Business (“GrowCo”)
FY 2014: $2 million; FY 2015: $3 million; FY 2016: $7 million; FY 2017: $10 million; FY 2018: $15 million.
Average (Three-Year Lookback): $10.7 million.
Average (Five-Year Lookback): $7.4 million.
Example #1, of course, is what Congress had in mind. A growing small business like GrowCo is well over the $7.5 million size standard using a three-year lookback, but still squeaks under using a five-year period. For GrowCo, the “small business runway,” if we really must use that unfortunate terminology, has indeed been extended.
But not every business is rapidly growing. Some companies face declining revenues. What happens to them under this new law?
Example #2 – Declining Large Business (“ShrinkCorp”)
FY 2014: $20 million; FY 2015: $10 million; FY 2016: $7 million; FY 2017: $3 million; FY 2018: $2 million.
Average (Three-Year Lookback): $4 million.
Average (Five-Year Lookback): $8.4 million.
Ouch! For a declining business like the downtrodden ShrinkCorp, the five-year rule forces a “large business” self-certification in 2019, whereas the three-year rule would have put the company comfortably under the size standard.
In fact, for these poor ShrinkCorp folks, it’s even worse than that. Right now, in December 2018, using a three-year look-back period of Fiscal Years 2015 through 2017, ShrinkCorp is small, with approximately $6.7 in average annual receipts. When the five-year period kicks in, ShrinkCorp will have to change its self-certification from small to large, despite steadily declining receipts.
That, of course, will make ShrinkCorp ineligible for small business set-asides in its primary industry. And if ShrinkCorp has obtained SDVOSB and/or HUBZone certifications, they’ll likely be terminated, even if ShrinkCorp wants to pursue contracts with different NAICS codes and higher size standards; each program’s regulations requires a participant to be small in its primary NAICS code. (The same is true for EDWOSB status, though, oddly, not necessarily for “regular” WOSB eligibility).
That, to use the official legal terminology, is really messed up.
Now, I doubt Congress had any intention of harming companies like ShrinkCorp. And I’m certainly not saying that the five-year period ought to be scrapped in favor of a return to the three-year standard.
But the fact is that five-year runway isn’t a universally good thing. For some growing companies like GrowCo, it will be a lifesaver. For declining companies like ShrinkCorp, it will result in the wrong kind of runway extension: a large business runway extension.
“Koprince,” you may be thinking, “I see what you’re saying, but we can’t have it both ways. It’s either three years or five. Looks like some declining companies are just going to have to accept large business status a little longer, for the greater good.”
Under the new bill, that’s exactly what will happen. But I don’t think it has to be that way. If I could offer Congress a modest suggestion for improvement, it would be this: use both formulas.
Yes, that’s right. For any company operating under a receipts-based size standard, have the company (and the SBA) run the numbers under both three-year and five-year periods. Then pick the lower result and use it to determine the company’s size status.
This approach would give growing businesses the benefit of a longer “runway,” while letting declining businesses more quickly jettison those “good years” and regain small business status sooner. A win-win, right?
Congress, if you’re reading, I hope you’ll take this idea to heart and get started working on the “Small Business Runway Extension (Or Not, As The Case May Be) Act of 2019.” And since it’s the holidays, and I’m in a giving mood, I won’t even invoice you for the idea. Talk about win-win!
In all seriousness, I hope policymakers think about whether further changes to the size standards might be advisable to prevent the five-year period from harming some of the very small businesses it was intended to assist. I’ll keep you posted.
Update (12/17/2018): President Trump has signed the bill into law.