SBA Affiliation Rules and Spin-Offs: Beware ‘Newly Organized Concern’ Affiliation

When a small business draws close to its size standard ceiling, it may consider forming a small business “spin-off” company as one way to keep itself in the small business set-aside game.  Done right, a spin-off may be able to successfully compete for and win small business set-aside contracts.

But be careful: if the spin-off doesn’t pass muster with the SBA, the “newly organized concern” affiliation rule may cause the spin-off to be ineligible for small business set-aside contracts, as occurred in Size Appeal of eTouch Federal Systems, LLC, SBA No. SIZ-5280 (2011), a decision of the SBA’s Office of Hearings and Appeals.

The eTouch Federal Systems case involved a spin-off created by eTouch Systems Corporation (which I’ll call “the Corporation” to avoid confusion with eTouch Federal Systems).  The Corporation originally created eTouch as a wholly-owned subsidiary.  The Corporation subsequently attempted to transfer its two federal government contracts to eTouch, though it never obtained the government’s consent to the novation.  An individual later purchased a majority interest in eTouch, but the Corporation continued to maintain a substantial minority interest.

After eTouch won a NASA contract, the NASA contracting officer filed a size protest with the SBA. (Yes, contracting officers can and do protest small business size status when they see a potential problem).  The contracting officer questioned, in part, whether eTouch was affiliated with the Corporation under the SBA’s “newly organized concern” affiliation rule.

The newly organized concern affiliation rule states that two companies are affiliated when four circumstances exist: (1) former officers, directors, principal stockholders, managing members or key employees of one company organize a new company; (2) the two companies are in the same or a related industry or field of operation (3) the individuals who organized the new company serve as its officers, directors, principal stockholders, or key employees; and (4) the “old” company furnishes or will furnish the “new” company with contracts or other forms of assistance.

In this case, SBA OHA held that the newly organized concern rule applied and created affiliation between eTouch and the Corporation.  First, SBA OHA noted that the Corporation itself had formed eTouch as a subsidiary.  SBA OHA held that this met the first criteria.  SBA OHA determined that the two companies were in related lines of work, meeting the second factor.  As for the third factor, although the Corporation had sold a majority of eTouch to an individual, “the fact that [the Corporation” retains a substantial minority interest in [eTouch] means that the interests of the two concerns are not separate.”

Finally, SBA OHA determined that the fourth factor was established because eTouch was serving as a subcontractor to the Corporation.  Because the Corporation had not obtained a novation of the contracts, the Corporation remained the nominal prime contractor, and all the work that eTouch performed was as a subcontractor to the Corporation.

OHA held that eTouch and the Corporation were affiliated under the newly organized concern rule.  As a result, eTouch was ineligible for the small business set-aside contract it had won.

The eTouch Federal Systems case is a good example of how the newly organized concern affiliation rule works in the real world.  If a company is contemplating a spin-off, it should make sure the relationship between your company and its spin-off does not meet all four factors of the newly organized concern affiliation rule, or it could end up on the wrong side of a size determination, just like eTouch.


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