Publications
03.28.11
Effective March 14, 2011 new rules went into effect for companies participating in the 8(a) program. These rules affect virtually all aspects of the 8(a) program including compensation levels and eligibility to participate. The new rules loosened some requirements for joint ventures (JV) but restricted other JV requirements. In balance, these rules may be detrimental for some 8(a) firms causing them to graduate long before they reach the small business thresholds. This article addresses the major changes and some concerns for small businesses in the 8(a) program. These rules do not affect other SBA programs.
New Eligibility Requirements
The SBA test of an individual for economic disadvantage has moved from two eligibility criteria of income and net worth to three eligibility criteria of income, net worth and fair market value of all assets. The eligibility requirements impact both initial eligibility and continuing eligibility.
Initial Eligibility
The changed or new initial eligibility requirements are:
Income levels
The SBA has set the initial income level average to not more than $250,000 per year based upon the average of the prior three years as the ceiling for initial eligibility to participate in the 8(a) program. The income includes bonuses and the value of company stock received in lieu of cash. It reserves the right to use a lower income level based on circumstances. However, no circumstances were described.
Fair Market Value of All Assets
The SBA now has a third criterion for initial participation, which is the fair market value of total assets for each individual applying as being economically disadvantaged. The total assets to be considered include the individual’s personal residence and stock or ownership interest in the 8(a) company. SBA has excluded retirement accounts from the total asset calculation. The initial value of total assets may not exceed $4 million to participate in the 8(a) program. SBA regulations do not state how the fair market value of the principal residence or company is to be determined.
Continuing Eligibility
To continue in the 8(a) program the new eligibility requirements are:
Income levels
The SBA has set the maximum average income level of $350,000, including bonuses and the value of company stock in lieu of cash based upon an average for the prior three years, as a ceiling for continued eligibility to participate in the 8(a) program.
Fair Market Value of All Assets
The new SBA continuing eligibility requirement sets the fair market value of all assets for an individual may not exceed $6 million. The total assets include the individual participant’s personal residence and the stock or ownership interest in the 8(a) company. It excludes retirement accounts. SBA regulations do not state how the fair market value of the principal residence or company is to be determined, or how often it is to be submitted.
The above changes are beneficial on the minority owner’s income because it raises income from a maximum of $300,000 to more than $350,000 when considering the new excessive withdrawal rule as discussed below. However, there are concerns that the new fair market value asset test will significantly reduce the number of firms eligible to continue participating in the 8(a) program.
Most Government contractors have North American Industrial Classification System (NAICS) codes that have small business size standard based on sales. The size standards generally are between $7 million and $35 million in average sale over the prior three years. Another measure for small business is the number of employees that is set between 500 and 1500 employees for certain manufacturing and production NAICS codes. In either case, the fair market value of a successful company with a primary NAICS code with a larger size standard may exceed the $6 million fair market value long before the company reaches certain size standards.
In the Washington DC area, for example, a residence value could easily exceed $400,000 together with savings, investments and personal property of up to $750,000 as permitted in the SBA net worth calculation, the fair market value of the company would not even have to exceed $5 million before a sole owner of an 8(a) company would exceed the total asset test. Failing any one of the three eligibility tests is a basis for graduating from the 8(a) program. It appears that this requirement may cause some successful sole owners to graduate from the 8(a) program before they exceed the size standard for its industry.
SBA has stated that if total fair market value assets exceed $6 million then it assumes that there is fair access to credit. However, we have found that credit at favorable rates is not generally available to small businesses. Thus, SBA may be graduating some 8(a) firms significantly before they have financially matured based upon this test.
SBA does not state whether it will require an independent valuation annually. If it does, 8(a) contractors will have to be careful about how the fair market value of the company is determined. The average “valuation expert” would not be aware of the effect 8(a) contracts have on the fair market value of the company and may overvalue it based on statistics of companies that are not in the 8(a) program. This is because a buyer must meet the recertification rules to keep the contracts it is purchasing. This essentially eliminates a buyer’s ability to keep the very contracts they are buying unless the buyer is another 8(a) company. Some independent valuation firms, such as the McLean Group, are well aware of the impact of 8(a) revenues on valuations. 8(a) firms need to ascertain that the independent appraisers understand the differences. SBA did not address in the regulation how it will determine if a fair market value submitted by an 8(a) firm is reasonable.
Excessive Withdrawals
A positive note is that the owners’ salaries do not count in the calculation of excessive withdrawals. The excessive withdrawal rule has been completely revised and no longer includes salaries of the owners unless the SBA believes that they are being used to circumvent the excessive withdrawal rule. The definition still excludes payments to owners of S Corporations, LLCs and Partnerships for the payment of federal and state income taxes. The regulation defining withdrawals now includes all compensation payments other than salary to officers and other key employees. However, a second paragraph indicates that such payments extend well beyond just officers of the company and includes all managers. It is not clear whether this was the intent of the regulation, but the inclusion of the word “managers” would include bonus and incentive payments to any contract managers and other management personnel for excessive withdrawal calculations.
The revised amounts to exceed that qualify as excessive withdrawals are:
- $250,000 for firms with revenues up to $1,000,000
- $300,000 for firms with revenues between $1,000,000 and $2,000,000, and
- $400,000 for firms with revenues in excess of $2,000,000
This may result in an increase in withdrawals paid to owners, but it may limit bonuses and incentives to non-owner officers and managers as an 8(a) firm gets larger.
Audit Requirements
Another concern for the 8(a) small business is the financial reporting requirements. Such financial reporting has been revised to increase the revenue size before audited financial statements are required. In addition, the first year an audited statement is required, the company may submit only an audited balance sheet.
The financial reporting levels for 8(a) companies is revised to:
- Compilation by CPA firm or in-house financial statements certified by an officer of the company for firms less than $2 million in revenue
- Reviewed financial statements by a CPA firm when the company revenue is between $2 million and $10 million, and
- Audited Financial Statements by a CPA firm when the company revenue exceeds $10 million.
This increase is appropriate. However, due to the total asset test, it may be that a successful sole owner 8(a) firm may not have to submit more than one or two years of audited financial statements to the SBA before it graduates from the program since the fair market value of the company combined with other assets of the owner may exceed the $6 million when the Company’s revenue level goes higher than $10 million thus forcing the company to graduate.
Joint Ventures
The rules for Joint Ventures (JVs) have significantly changed. For both normal JVs and mentor protégé JVs the rules have been standardized. For any JV the 8(a) firm must have 51% ownership and perform 40% of the work effort. However, mentor protégé JVs still have an advantage of not counting the mentor as an affiliate toward the size standard for the 8(a) firm.
The SBA has changed the rules for JVs from three proposals to three awards in two years. The actual JV may be awarded more than three awards because SBA may “certify” it was eligible to submit additional proposals when two or fewer awards have been made to the JV. Subsequent to submitting the additional proposals, the JV may receive one or more additional awards. Once the JV receives three awards, it is no longer eligible to propose on additional Government procurements.
This represents a significant change because previously JV use was limited to submitting three Government proposals. However, such JVs may not have actually received any awards and were restricted from submitting any additional bids. This led to additional administrative cost for the 8(a) companies that would have to create a different JV to submit additional proposals for Government contracts. The new rule still restricts the JV to a two year period for obtaining contracts, but the JV may continue to submit new proposals until it actually receives 3 contract awards.
Additional Requirement Changes include
Subsequent Small Disadvantaged Business Status
If an 8(a) firm is terminated or graduates from the program, it may not self certify as a small disadvantaged business, unless SBA approves it. This has not been true historically, since graduating from the 8(a) program did not in any way mean that the company was no longer disadvantaged. SBA now assumes that the company is no longer “economically” disadvantaged.
8(a) Contract Reporting
Every year the firm must submit performance of work reports for each 8(a) contract issued to it or one of its JVs. The report states how the work performance requirements are being met for each of its 8(a) contracts.
Office of Inspector General Size Determination Requests
Under a new rule the OIG will be able to request a formal size determination for companies under any SBA programs.
Being Called to Active Duty
SBA has a new regulation that permits any disadvantage individual participating on the 8(a) program that is in a military reserves unit called to active duty to appoint an individual to act in his or her place and continue in the 8(a) program. He or she may also elect to suspend participation in the program until the disadvantaged individual returns from active duty.
Prior Approvals by SBA
SBA requires that all 8(a) JVs bidding on 8(a) contracts obtain SBA approval of the JV agreement prior to contract award. For non-8(a) contracts, SBA does not require SBA approval before the award, but the ownership and participation in work requirements for the 8(a) JV must still be met.
All mentor protégé agreements must be approved before the award of any 8(a) contracts to a mentor protégé JV.
Closing Remarks
The SBA rule revisions are going to have a mixed result for many firms participating in the 8(a) program. While SBA has made several changes that are to an 8(a) firm’s advantage, such as compensation and JV rules, it has also made some rules that are not. The primary change in the rules that may harm the length of participation in the 8(a) program for successful owners is the new fair market value of all assets test. We expect many successful 8(a) companies to exceed the $6 million total asset value before they exceed the size standards for their NAICS codes and significantly before the 9 years of the program.
It appears that these rules will have positive impacts in the short term for getting 8(a) small businesses new contract awards. While the opportunities are increased to get new contracts, the average stay within the program may significantly decrease for successful companies with larger size standards. The minority owner(s) each have to qualify as socially and economically disadvantaged. Where there are multiple owners of a participating firm, the fair market value of the participating firm appears to be based on the percentage of the ownership. Thus, it will also be more difficult for the successful sole owners to remain in the 8(a) program because the total value of the company will be included in the total asset test.
It also means that companies of the same size with minority disadvantaged owners that own less than 100% of the company will stay in the program longer, since it takes longer for the individual owner’s fair market value of total assets to exceed $6 million.
This means a successful sole owner may graduate the 8(a) company because the fair market value of his or her assets exceed $6 million, while an 8(a) competitor of the same size and value with multiple minority interest owners could stay in the program because the fair market value of the principal owner’s share is lower. For example, if the principal owner owns 60% of the entire company then only 60% of the value of the Company is included in his or her total assets for purposes of developing their total assets for the test.
Another issue that is not addressed is whether the SBA will dilute the fair value of the ownership interest in cases where there are stock options that would dilute the ownership percentage if exercised. This is an SBA requirement when determining the ownership percentage for the minority owner(s).
These and other issues will need to be addressed by the SBA in implementing the final regulation. The SBA needs to address the actual calculation; documentation and reporting requirements for a new fair market value of total assets test. Without such guidance the implementing SBA offices may apply such tests inconsistently.
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