Avoiding affiliation with other companies can be critical to qualifying as a small business under the SBA’s rules for government contractors. But not all SBA affiliation rules are intuitive, and in my career as a government contracts attorney I have seen the same misconceptions about the affiliation rules come up time and and time again.
So without further ado, here are five common misconceptions about the SBA’s affiliation rules.
- An Affiliate Can be in an Unrelated Industry
Business owners frequently assume that another company cannot be an affiliate if that company operates under a different primary NAICS code–particularly if the industries aren’t closely related. For example, an individual who owns 100% of an an IT services company and a real estate holding company might believe that two companies are not affiliated because they are in very different lines of work.
At first blush, this assumption may have some logical appeal. But think about it: what if Google–which is on track for more than $200 billion in 2021 revenues–formed a wholly-owned subsidiary operating in, say, the general construction industry? It would hardly be fair to the mom-and-pop contractors of the world to say that this new entity is a “small business” even though it is backed by the full power and resources of one of the world’s dominant companies.
The bottom line: other than the SBA’s “newly organized concern” rule, 13 C.F.R. 121.103(g), the fact that a potential affiliate operates in a different line of work or different primary NAICS code is not relevant to the SBA’s analysis.
2. Affiliation Doesn’t Require Common Ownership
Two companies may be affiliates where they share common ownership–but contrary to another common misconception, affiliation may exist even if the companies have no shared owners.
For example, let’s assume that Sally is the Chief Executive Officer (the highest officer position) in two companies: SmallCo and BigCo. Although Sally runs each company’s day-to-day operations, she does not own an equity interest in either company. So are the companies affiliates?
Almost certainly, under SBA’s “common management” rule, 13 C.F.R. 121.103(e), which says that affiliation arises where a person who controls the management of one company also controls the management of another. Several other bases of affiliation may also exist without shared ownership, such as affiliation based on economic dependence, familial relationships, or the previously-mentioned newly organized concern rule.
3. Your Affiliate Might Not Know
In my experience, the so-called “economic dependence” affiliation rule is often one of the most difficult for contractors to wrap their minds around. This rule, 13 C.F.R. 121.103(f)(2), says that the SBA may presume that one company is affiliated with another “if the concern in question derived 70% or more of its receipts from another concern over the previous fiscal years.”
Let’s say that Bob owns 100% of BobCorp, which has been in business for six years. Over that time, BobCorp has generated 95% of its revenues from subcontracts with Google–which reported a whopping $55.31 billion in revenues for the first quarter of 2021.
The SBA will presume that BobCorp is affiliated with Google, even though Bob is almost certain to say, “but Google has no idea that they’re my only major customer!” Perhaps Bob will be able to rebut the presumption of affiliation, though in my experience I’d say the odds are slim. The economic dependence presumption applies even if the entity responsible for 70% or more of a company’s revenues doesn’t know that they’re the company’s chief customer.
4. “Putting Your Spouse in Charge” May Not Prevent Affiliation
Business owners who intuitively understand that affiliation may arise if the same person controls two companies often propose what undoubtedly seems like an elegant solution: “well, I’ll just put my spouse in charge of the other company!” Seriously, I have heard this one a lot over the years.
I’m no marriage counselor, so I can’t comment on the fact that plenty of spouses appear ready, willing and able to be “put” in nominal control of various contractors. But the fact that I’ve heard this one a lot means that the SBA has too–and it has developed a rule to address affiliation between companies controlled by spouses or other close family members.
Under the so-called “familial relationships” affiliation rule, 13 C.F.R. 121.103(f)(1), “firms owned or controlled by married couples, parties to a civil union, parents, children and siblings are presumed to be affiliated with each other if they conduct business with each other, such as subcontracts or joint ventures or share or provide loans, resources, equipment, locations or employees with one another.”
The presumption doesn’t apply when the close relatives truly aren’t involved in one another’s businesses. But, in my experience, many business owners who float the notion of putting a spouse in charge are thinking of the spouse’s role as more of a figurehead to allow the business owner to evade the affiliation rules. That’s a tough sell when it comes to the SBA that there is no affiliation.
5. Ownership Below 50% Can Create Affiliation
Many business owners intuitively understand that someone who owns 50% or more of a company may control it for purposes of the SBA’s affiliation rules. (Affiliation, at its heart, is the question of common control or the power to control). But those same business owners often believe that the opposite must also be true: that an ownership interest below 50% can never create affiliation. That, unfortunately, is a mistake.
Let’s return to our fictional friend Bob, the 100% owner of BobCorp (and put aside Bob’s affiliation problem with Google for the time being). Assume that Bob also owns 49% of REPRos, a real estate investment company. Two other individuals own 25% and 24% of REPros, respectively. Does Bob’s 49% interest create an affiliation with BobCorp?
Yes! Under the SBA’s “common ownership” rule, 13 C.F.R. 121.103(c)(1), a person who owns “a block of voting stock which is large compared to other outstanding blocks of voting stock, controls or has the power to control the concern.” And, of course, Bob’s 100% ownership of BobCorp means that Bob controls both companies. Presto, affiliation!
Bob is probably saying, “but wait! Under REPros’ bylaws, unless one of the other two owners votes with me, I don’t have the power to make REPros do anything! How can I possibly be in control?” It’s a logical response, but SBA’s reply is, essentially, “we don’t care.” The SBA believes that someone must be in control of a company at all times, and because Bob’s ownership share is the highest, Bob is a better bet than either of the other owners.
Control may also exist under 13 C.F.R. 121.103(c)(2) when multiple owners all own shares that are “equal or approximately equal” in size, such as four 25% interests. In fact, in one rather shocking case, an individual was found to control a company where he owned one share out of 120 because all the other owners also owned one share!
So there you have it: five of the most common misconceptions I see regarding the SBA’s affiliation rules. While some of these rules are intuitive, others most certainly are not. For any company intending to qualify as a small business for federal government contracts, it is very wise to fully understand these rules and proactively take any necessary remedial steps before the SBA comes calling.
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