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Small Business Relationships – The Wrong One Can Ruin Your Status as a Small Business

In federal government contracting, small businesses that have been awarded the status by the federal government as a “small” business are eligible to receive federal government contracts that are specifically “set-aside” for small businesses and other benefits designed to help them grow and prosper.

But, your status as a small business may be destroyed if your business “affiliates” with another business or even a person; and, that affiliation results in revenue and employees that exceed the small business size limits the government has set.

Regulations give some definition around when the federal government considers a small business to be affiliated with another business or person. But, the definitions are not clear or actionable; but, instead are flexible and depend on a number of factors. When partnering, forming joint ventures or even bringing on new owners and leaders, a small business needs to be sure it does not create an “affiliation” and by doing so destroy its status as a small business.

Generally, a small business is considered affiliated with another business when:

  • One of the businesses controls the other
  • One of the businesses has the power to control the other
  • When a third party controls or has the power to control the small business.

Whether control is actually exercised does not matter for the purpose of defining an affiliate. Instead, the government looks to determine whether a business or person has the power or authority to control the small business.  Affiliation may occur when control is either direct or indirect and, it does not matter if the entities are organized for profit or not.

The definition of control includes the traditional notion of managing or otherwise controlling a business but it also includes “negative” control which is the ability of a person or entity to prevent or limit an organization’s actions. For example, when by-laws afford a minority shareholder the right to block action, the shareholder has “negative” control.

A small business will likely be considered an affiliate if one or more officers, directors, managing members, owners or partners of another business controls or manages the small business.

Similarly, if a small business has the identical or substantially identical interests to another person or another business, the federal government will likely consider the entities to be affiliated. The interests may be either business interests or economic interests. For example, family members or investors with common interests in the success of the small business are considered to have an identity of interest. Also, businesses with common investments, contractual relationships or that are economically dependent on one another are considered to have common interests and therefore may be considered affiliates.

The government may also determine a small business is affiliated with another business if another business or person owns or has the power to control 50% or more of a small business’ voting stock. Even if stock ownership is less than 50%, if a person or business owns or has the power to control a block of a small business’ voting stock which is large compared to the control of other stock, the small business may be considered affiliated with those owning or controlling that block of stock.

However, these arrangements do not mean that a small business is definitively considered an affiliate of another business as long as the two businesses can clearly demonstrate that the two are separate and do not control one another.

When a small business agrees to work with another business to pursue a defined venture by combining all or some of their effort, property, funds, skill, or knowledge they are considered a joint venture.

Depending on the circumstances, the government may determine that a small business is affiliated with the other business in a joint venture and, if so, the small business will lose its status. For example, if any member in the joint venture seeks SBA financial assistance in connection with the joint venture, the entities in the joint venture are considered affiliates; and the small business may lose its status as a small business. A small business that is part of a joint venture may be considered an affiliate of the other business in the venture if the joint venture pursues more than three federal government contracts over a two-year period.

On the other hand, joint venture members will generally not be considered affiliates if each member is a small business as defined by the size standard for the procurement the joint venture is pursuing. However, the government may look to the combined annual receipts or employees of small businesses that make up the joint venture to determine if the joint venture members meet the size standards for the procurement.

A joint venture between a small business protégé and their approved mentor business does not result in an affiliate relationship if the government approves the joint venture agreement prior to contract award and the joint venture has not reached certain dollar limits.

As for merging with another company, the government, depending on the situation, may determine that the agreement to merge may establish affiliation. However, agreements to negotiate the possibility of a merger or an acquisition or stock sale that will occur at a later date are generally not considered affiliation.

In the prime-subcontractor context, if a subcontractor performs vital aspects of a contract or task order or, if the prime contractor is unusually reliant on a subcontractor then, the two businesses may be considered joint venture partners, not a prime-subcontractor; and as a result, they may be affiliates.

Since the federal government looks at the “totality of the circumstances” when determining whether two entities are affiliates, if you are a small business you should the circumstances of your relationships with other businesses, advisors and investors.  Doing so will help you assess whether the government will consider your business to be affiliated with another entity and thereby possibly destroying your small business status.

For example, consider the following:

  • Do the owners of your small business also own or invest in other businesses?
  • Does your small business management team also manage other businesses?
  • Does your small business share key personnel or even employees with other businesses?
  • What is the nature of any contractual relationship your small business has with other entities or individuals:  Joint venture? Subcontract? Advisors? Investors? Owners?
  • Does your small business share functions such as finance, contract management, HR, IT, or legal with another entity?
  • Does your small business share facilities or equipment with another entity?
  • If you are in a prime-subcontractor relationship – what is the percentage of work that each party is performing; how are administrative responsibilities like contract management and invoicing shared?
  • If pursuing an opportunity with a teaming partner or joint venture partner, what are the size standards for that particular pursuit?

It’s important for a small business federal government contractor to think through its business relationships and the implications of those relationships. For as the famous management consultant Peter Drucker once said:

“[B]usinesses grow through alliances – all kinds of dangerous alliances.  Joint ventures, and customer partnerings which, by the way, very few people understand.”  Peter Drucker, management consultant, author, educator.

And remember, for a small federal government contractor, these alliances may be particularly dangerous because if your alliance results in what the government considers to be a misrepresentation of your status as a small business, the government proves Drucker’s statement on the dangers of alliances by pursuing:

  • Debarment and/or suspension of the business and individuals involved
  • Civil False Claims Act violations which include fines and penalties against the business and individuals involved
  • Criminal violations that include fines, penalties and incarceration
The intersection of law, business, criminal activity crime and ethics: why do some companies violate the law? what happens when they do? what is ethical? how do we get corporations to follow the law? can lawyers help and, if so, what is the lawyer’s role? Stay tuned, we’re going to address all of these issues and more in When the Writ Hits the Fan.

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