The Story Behind the Mid-Size Squeeze

There has been a lot of discussion of late about how mid-sized companies are feeling “squeezed” out of a lot of acquisition opportunities. It’s not really a new phenomenon, but it does seem to be getting worse lately. And it may get a lot worse before it gets any better.

Before we dive into why the “mids” are getting squeezed, let’s lay some foundation.

Acquisition size basics

The Government divides the entire GovCon community into two groups: small and not small. There isn’t anything else and that’s part of the problem.Small businesses (and all the other classifications covered by the SBA’s socio-economic acquisition goals)get preferential treatment in competing for contracts and are exempt from some regulations.

- Some solicitations are “set-aside” for small businesses and no
other firms may participate

- Small businesses may receive preferential treatment in
competitive source selection decisions even when the solicitation
is not set aside for small businesses

- Small businesses are exempt from Cost Accounting Standards
compliance requirements and some FAR compliance requirements

- In set-aside situations, small businesses are very attractive to
large businesses as a prime to which they can be a subcontractor

- Small businesses are very attractive to large businesses as a
subcontractor to help them meet the small business subcontracting
goals mandated on some contracts

Firms that are not small (referred to as “large businesses” in the regulation) do not receive any preferential treatment and the size standards promulgated by the SBA put firms into this status at a relatively early stage of their growth. There are significant disadvantages to being a recently reclassified (or graduated), formerly small, business.

- Large businesses are required to comply with all FAR and CAS
requirements

- All “large businesses” compete for contracts in the same
environment regardless of actual size or market dominance

The Government does not recognize “mid-sized companies” as a group requiring special protections or preference in contract source selections.

Size matters!

When small businesses “outgrow” their size standard and lose their preferences, protections and exemptions, they are immediately treated as being equal to a Lockheed Martin, an L3 or a Northrop Grumman. In reality, their access to credit, their ability to attract human capital and their overall ability to win in a “full and open competition” environment is unchanged.

When small businesses lose their preferences and protections, they also lose their attractiveness to large businesses as a partner either as a prime to whom they can subcontract or as a subcontractor

Until the rules changed last summer (7/1/07), small businesses were attractive as acquisitions because the contract “vehicles” they held retained their set-aside eligibility after the acquisition. Many small businesses’ acquisition valuations were artificially inflated as a result. The new rules require the status of all vehicles eligible for set-aside procurements to be recertified upon completion of any merger or acquisition. This almost always results in loss of the special status of the vehicles and makes them virtually worthless to an acquiring company. Acquisition by a large business is no longer a viable exit strategy for many small businesses approaching “graduation” from their small status.

To put it bluntly, graduating from small to mid-sized is often NOT a cause for celebration. Some small firms are now actually considering intentionally restricting or slowing their growth to delay that event.

The Squeeze gets worse

Some recent statutory or regulatory initiatives are expected to make the situation worse for mid-sized businesses. Some initiatives still under consideration are also expected to have an adverse effect.

The same rule changes that affected small business M&A valuations also changed how the Federal Government “takes credit” for the dollars spent with small businesses. The recertification requirement was retroactive (forever) and resulted in loss of status for all set-aside eligible vehicles held by large businesses. That loss of status means that much of the spending the Government used to “count” as going to small businesses has been moved from the small business column to the large business column. Instead of just barely making the statutory 23% goal for small business procurement spending, the Small Business Administration (SBA) now acknowledges that the actual achievement against goal was really about 18%, a shortfall of more than 20%.

The SBA has notified all agencies of increased emphasis on and oversight of the procurement process to ensure that additional set-aside opportunities are identified to make up the shortfall. And, if that weren’t enough, the SBA reauthorization bill currently before Congress increases the goal from 23% to 30%.

In short (too late?), a lot of the agencies’ discretionary spending budget has been taken out of the large business (full and open competition) environment and earmarked as available exclusively for small businesses.

Much of the discretionary budget (at least in DOD) is associated with major systems acquisitions for there is NO reasonable expectation of success for a mid-size business. Mid-sized Government contractors simply do not build ships, aircraft or tanks. As the pool of available contracts they COULD win shrinks, so do their fortunes.

Now what?

On top of everything else, the size standards used by the SBA to draw the line between small and not small have not kept up with inflation. Many mid-size businesses say that they are still very small relative to the Defense giants with whom they must compete. Some argue for a new mid-size classification with modified preferences and protections.

Now that M&A is much less attractive as an exit strategy for the small business owner, it is anticipated that many more companies will transition to the no-man’s land of the mid-size contractors at the same time that the opportunity pool is shrinking.

It may not be a particularly good time to be a “mid,” but being small is looking better and better. Anyone want to start a small business?