Joint Ventures and the Limitations on Subcontracting: SBA Provides Some Clarity

Joint ventures operating under the SBA’s regulations are subject to two work share restrictions: the limitations on subcontracting, which governs work share between the joint venture and its subcontractors) and the so-called “40 percent rule,” which governs work share between the joint venture partners.

It can be easy to get confused about how the rules work together. Fortunately, in a new rule published on October 16, SBA has provided some much-needed clarity.

First, SBA clarifies how to calculate compliance with the 40 percent rule. In the context of small business joint ventures, the 40 percent rule says that “[t]he amount of work done by the partners will be aggregated and the work done by the small business protege partner must be at least 40% of the total done by the partners.” Similar statements exist in the 8(a), SDVOSB/VOSB, WOSB/EDWOSB and HUBZone joint venture regulations.

But what, exactly, does “work” mean? It it calculated by labor hours? Dollars? If the latter, are certain expenditures excluded from the calculation, like materials from a construction contract? I’ve heard all sorts of theories over the years. My response, generally, has been something along the lines of, “I can’t tell you with absolute certainty, but the only thing that makes logical sense to me is to use the same formulas the SBA uses to calculate compliance with the limitations on subcontracting.”

Now, SBA has confirmed that this is the correct approach. (Hey, it’s nice to be right sometimes!) In the new rule, SBA writes “SBA has always intended that the same rules as those set forth in § 125.6 should generally apply to the calculation of a protégé firm’s workshare in the context of a joint venture.” 13 C.F.R. 125.6, of course, is where you’ll find SBA’s limitations on subcontracting rules.

This means that calculating compliance with the 40% minimum requires measuring dollars, not labor hours. It also means, as SBA says in the new rule, that “the rules concerning supplies, construction and mixed contracts” under the limitations on subcontracting regulation “apply to the joint venture situation.” Just like under the limitations on subcontracting, certain costs (like materials for construction contracts) are excluded.

Second, SBA has addressed confusion regarding whether the “similarly situated entity” concept also applies to the 40% rule. A similarly situated entity is defined as a subcontractor that has the same socioeconomic status as the prime contractor, such as 8(a) status for an 8(a) acquisition. A similarly situated entity must also be a small business “for the NAICS code that the prime contractor assigned to the subcontract the subcontractor will perform.” When a subcontractor qualifies as a similarly situated entity, the SBA’s limitations on subcontracting rules allow the prime contractor to count the subcontractor’s work toward the prime’s self-performance requirement.

Some small business proteges have wondered whether they can meet the 40% minimum by subcontracting some of that work to a similarly situated entity. In the new rule, SBA gives an unequivocal answer: no.

SBA writes that it “has never intended that a protégé firm could subcontract its 40 percent performance requirement to a similarly situated entity.” In other words, SBA says, it has “always believed that the protégé itself must perform at least 40 percent of the work to be performed by a joint venture between the protégé firm and its mentor, and that it cannot subcontract such work to a similarly situated entity.”

SBA explains:

The only reason that a large business mentor is able to participate in a joint venture with its protégé for a small business contract is to promote the business development of the protégé firm. Where a protégé firm would subcontract some or all of its requirement to perform at least 40 percent of the work to be done by the joint venture to a similarly situated entity, SBA does not believe that this purpose would be met. The large business mentor is authorized to participate in a joint venture as a small business only because its protégé is receiving valuable business development assistance through the performance of at least 40 percent of the work performed by the joint venture. Thus, although a similarly situated firm can be used to meet the 50 percent performance requirement, it cannot be used to meet the 40 percent performance requirement for the protégé itself.

SBA then provides a helpful example:

[I]f a joint venture between a protégé firm and its mentor were awarded a $10 million services contract and a similarly situated entity were to perform $2 million of the required services, the joint venture would be required to perform $3 million of the services (i.e., to get to a total of $5 million or 50 percent of the value of the contract between the joint venture and the similarly situated entity). If the joint venture were to perform $3 million of the services, the protégé firm, and only the protégé firm, must perform at least 40 percent of $3 million or $1.2 million.

Over the years, I’ve addressed countless questions about how to calculate compliance with the 40 percent rule. I’ve also seen plenty of confusion about whether a protege can use similarly situated entities to meet the 40 percent threshold. Kudos to SBA for providing clear guidance on these important subjects.

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