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Building Entrepreneur - Fall/Winter 2017
By: Ed DeLisle & Maria Panichelli
It’s no surprise that in today’s market, with a growing number of Federal government contracts set-aside for various types of small businesses, teaming relationships are increasingly popular. Large contractors like teaming because it provides them access to contracts for which they would otherwise be ineligible. Small businesses know that teaming is a good way to break into the federal contracting arena, an arena in which experience and past performance can prove critical to securing a contract. By teaming with a more experienced, larger contractor, a small company can acquire the experience needed to secure future federal contracts on its own. However, teaming is not without its downsides.
For small businesses, in particular, teaming can pose significant risks. If done improperly, teaming can destroy a concern’s "small" business status, otherwise render it ineligible to participate in the various Federal small business programs, or cause other compliance issues. Two common problems are: (1) a finding of "affiliation" pursuant to 13 C.F.R. § 121.103; or (2) violation of the percentage of work requirements set forth at 13 C.F.R. § 125.6. Small businesses need to be educated about these common pitfalls, and how to avoid them. This article seeks to do just that.
"Affiliation" can alter a small business’ size and render it ineligible to compete for small business set-aside contracts. When two companies are found to be "affiliated," their respective sizes (determined by either revenue or number of employees) are added together; the total is what is evaluated when determining whether the company is actually "small" based upon the SBA’s "Small Business Size Standards." If the sizes of the two businesses, added together, exceed the applicable size standard, neither can be considered "small." Accordingly, a finding of "affiliation" is something small businesses want to avoid.
Affiliation is governed by 13 C.F.R. § 121.103, which explains that "concerns and entities are affiliates of each other when one controls or has the power to control the other, or a third party or parties controls or has the power to control both. It does not matter whether control is exercised, so long as the power to control exists." In assessing whether or not two businesses are affiliated, the SBA considers factors such as common ownership or management, previous relationships with or ties to another concern, contractual relationships and financial reliance; the SBA may find affiliation even though no single factor is sufficient to constitute affiliation. In the teaming context, affiliation generally occurs in one of two ways.
First, a teaming relationship on a single project can result in a finding of affiliation under the "Ostensible Subcontractor" rule. The Ostensible Subcontractor rule holds that a small business that "is unusually reliant" on a subcontractor will be deemed affiliated with that subcontractor for size determination purposes. In other words, a small business can run afoul of the SBA’s affiliation rules if the small business teams with a subcontractor on a particular project, but then allows that subcontractor to control that project. In order to determine whether the subcontractor is, in fact, in control of a given project, the SBA will look to a variety of factors, including, but not limited to: whether it is the small business prime contractor or the subcontractor that is performing the vital components of the project; whether the small business prime contractor is financially reliant on the subcontractor; whether the small business has the requisite experience or managerial capability to control the project; and whether it is the small business prime contractor or the subcontractor who is, in reality, controlling the means and methods necessary to successfully complete the project. If the subcontractor appears to be the party in control, the SBA is likely to find that the small business prime contractor and subcontractor are affiliated.
Affiliation can also occur when there is an ongoing relationship between two companies, where one business appears to control the other, or where the two companies appear too closely related or intertwined. In the teaming context, this type of general affiliation can occur if a small business repeatedly teams with the same subcontractor/teaming partner, is financially reliant on its teaming partner, shares employees, office space, equipment or other resources with the teaming partner, or if the small business and its teaming partner have common ownership. Familial relationships or previous employee/employer relationships are also considered to be signs of affiliation.
By now you should be asking, "How do I avoid affiliation?" The advice we give our clients is simple: maintain control over your company and every project on which you are the prime contractor. If you are going to team with a subcontractor, make sure you do not have other ties to that company. If possible, avoid teaming with companies owned by family members, or companies at which you were previously employed. If you must team with such a company, be very careful that you do not appear reliant on, or intertwined with, that business. Hire your own employees, rent your own office space, and secure your own equipment. Do not allow your company to rely too heavily or regularly on a teaming partner for financial support, and avoid having another business serve as a guarantor of your credit line. Team with different concerns, rather than repeatedly teaming with the same company, especially if you have other ties (financial, familial, or work-related) to that company. Overall, maintain corporate formalities, and ensure that all transactions with other companies are made at arms-length. These tips should help you avoid a finding of general affiliation.
To avoid the perils of the "Ostensible Subcontractor" rule, the same type of principals apply. You may enter into subcontracts, but make sure that you retain control over how the subcontract is performed. Do not rely on subcontractors for financial assistance, or expect them to supply the managerial experience needed to complete the project. Perhaps most importantly, do not allow subcontractors to take over or perform the most vital aspects of the contract. Also, make sure your company performs the requisite percentage of work, as discussed below.
When the federal small business set-aside programs were created, there was some concern about “pass-through” situations – i.e. situations in which a small business, awarded a set-aside contract, would subcontract almost all the contract work to a large business. This kind of set-up would divert government dollars from the intended small business beneficiaries, and thereby negate the purpose of the agency’s small business programs. To avoid this problem, SBA enacted 13 C.F.R. § 125.6, which establishes minimum self-performance requirements for small business prime contractors performing various types of set-aside contracts.
The percentages vary depending upon the nature of the contract (services, supplies/products, general construction or specialty construction) being performed. In the case of service contracts, and supply or products contracts (other than from a nonmanufacturer of such supplies), a prime contractor on a set-aside contract cannot subcontract more than 50% of the amount paid to the prime contractor by the government. On a general construction contract, a prime contractor on a set-aside contract cannot subcontract more than 85% of the amount paid to the prime contractor by the government; in a specialty construction contract, the limitation is 75% rather than 85%. (With regard to both general and specialty construction contracts, the cost of materials is excluded and not considered to be contracted). An important exception to these limits, though, concerns subcontracts to “similarly situated entities.” Pursuant to the revised version of 13 C.F.R. § 125.6 enacted in 2016, such subcontracts will not count to the above-mentioned cap. A similarly situated entity is defined as “a small business subcontractor that is a participant of the same small business program that the prime contractor is a certified participant and which qualifies the prime contractor to receive the award.” In other words, a HUBZone could subcontract to another HUBZone, or an 8(a) could subcontract to another 8(a), without counting those subcontracts towards the applicable limit. A common question is how to calculate compliance when the similarly situated subcontractors themselves enter into lower-tier subcontracts. When drafting the revised regulations, the SBA was concerned that if compliance was determined by looking at first-tier subcontractors only, a first tier “similarly situated” subcontractor could, in turn, pass its subcontract through to a large or otherwise not similarly situated entity through a second subcontract. In doing so, they could circumvent the purpose of the regulation entirely. To address these concerns, the SBA explained in the final rule that work that is not performed by the employees of the prime contractor or employees of the first-tier similarly situated subcontractors will count towards the subcontracting cap. As you can see, this can quickly become a complicated issue that requires legal assistance to evaluate.
Failure to comply with these subcontracting limitations can result in a host of negative consequences. It is, therefore, vital to demonstrate to the SBA your compliance with these regulations. To that end, small business prime contractors should include in every teaming agreement (and related subcontract) the percentages (by number) and the specific scopes of work (by description) that will be performed by the small business prime contractor.
In summary, it is important for small business contractors to remain cognizant of the rules pertaining to affiliation and self-performance when entering into teaming agreements. Failure to pay attention to these issues could result in the loss of a concern’s eligibility to participate in small business programs. In contrast, if a small business is aware of the issues above, is careful to avoid such pitfalls, and properly structures its teaming relationship, teaming can be a rewarding and very profitable experience. If you have any questions about how to properly team, contact a legal professional.