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SMALL-BUSINESS REPORT

Potential acquirers back away in light of U.S. rule on contractors

A company taken over may no longer qualify for government work aimed at small firms. That's deterring buyers.

September 13, 2007|Cyndia Zwahlen | Special to The Times

Phone calls from suitors have dried up at Jim Lasswell's small professional services firm.

Potential buyers have gotten cold feet because of new Small Business Administration rules that make it likely that the San Diego federal contractor, if acquired, would no longer qualify for government work aimed at small businesses.

"I had a number of companies that were actively pursuing us, and they all ran away," said Lasswell, president and senior engineer of Indus Technology Inc., which posted $20 million in revenue last year.

Merger-and-acquisition activity nationwide is being slowed by the uncertainty over the rules, which went into effect June 30, experts said.

The number of deals involving small contractors could drop by 15% to 20% this year, said investment banker Jerry Grossman, a managing director in Houlihan Lokey Howard & Zukin's Washington, D.C., office. Normal volume is 90 to 100 transactions a year, he said.

Values are also suffering as buyers consider the risk that a small firm, once bought, won't get any more federal small-business contracts.

"Some buyers say, 'I'm not going through the brain damage of trying to figure out what the probabilities are.' Other buyers are just coming in and lowering the price," Grossman said.

Some industry groups are also buzzing with concern. Stopping implementation of the rules was a hot topic at an industry round table held in Dallas last week by the Contract Services Assn. Members of the trade group have voted it into their top-10-issues list for 2007.

The slowing of acquisition activity is an unintended consequence of the new rules, which require small firms to recertify their size more often. The rules are meant in part to address criticism that small-business contracts were too often held by big companies.

That could happen if the small firm outgrew its size standard during a contract or a large firm acquired it. Under the old rules, it could keep its small classification for the life of the contract, which, with options, could run as many as 20 years. Classification coding errors and fraud have also been concerns.

After considering the idea to require all small contractors to recertify their size every year, the SBA issued rules last November that require recertification at least five years into a long-term contract. A small company also has to verify that it still meets size standards every time its federal customer exercises a contract option, which typically happens at one-year intervals.

What's affecting Indus Technology and some other small contractors is the requirement that a small business recertify its size within 30 days of being acquired by or merged with another company.

For many buyers, it is small companies' special status and access to potentially billions in federal contracts tagged for small businesses that attracted them in the first place.

Though the rules don't require a federal agency to yank a contract from a small business when it is bought, the agency will no longer be able to count the contract toward its small-business goals.

Because most federal entities have been under pressure to increase the share of business they award to small firms, potential buyers worry that agencies will be less willing to award contracts to an acquired small firm or unwilling to exercise the series of one-year options many contracts contain.

To make it more complicated, the SBA says the recertification rule is retroactive. That means it applies to any merger or acquisition that has occurred during the life of an existing contract, not just to deals done after June 30.

"It's clearly a problem for the small-business community because the companies that acquire them are concerned about it," said Colleen Preston, senior vice president of public policy for the Contract Services Assn. in Arlington, Va.

The SBA and others meant for the rules to open up more contract opportunities for small businesses. The agency's overall goal is supposed to be to encourage a strong small-business community. Often called the engine of the national economy, small firms generate much of the innovation and jobs in the country.

A report last week by Automatic Data Processing Inc. showed that companies with fewer than 50 employees added 44,000 jobs in August while large-business employment dropped by 6,000 jobs.

Small federal contractors play an important role in local economies too, especially in Southern California, where there is a large concentration of military and general government customers.

Preston said her group agreed that the SBA rules addressed a significant issue -- large companies holding small-business contracts, possibly for decades. The expectation is that the rule requiring a small firm to recertify at least five years into a long-term contract would help fix that problem.

But her group wants a change that would give that same five-year protection to small companies that have merged or been acquired.

"There is an endpoint, but at least there is some certainty," Preston said.

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