(Editor’s Note. Increasingly, we are seeing contractors buying and selling whole or parts of businesses to be able to more effectively compete in the government marketplace. Our consulting practice has become more involved in the due diligence process of these transactions where we provide insights from our government cost and contracts expertise. We have written about the issue in the past and put together some basic considerations from both those articles and new insights from our consulting practice)
We have been seeing many instances where acquiring another federal contractor has been seem as creating many potential advantages. Whether by eliminating duplication of effort or combining two business bases to increase the denominator of the indirect rate calculation, combining two can lead to reduction in overhead and G&A rates making the new business more cost competitive. A purchaser can gain the experience of the company it buys thereby creating the opportunity to create new areas of work. One company can compliment the strengths of another –for example, we have seen one company with a strong specialty or positive relationship with an important buying office while the other company brings much needed financial backing needed to take advantage of great new opportunities. We have seen the much discussed “synergy” become a reality under the right circumstances. Done correctly the acquisition process can be a smooth transition to a combined stronger entity. Done incorrectly, the acquisition process can be frustrating, creating distrust and misunderstandings often landing in court where only t he lawyers benefit.
Contracting Considerations
A critical consideration in acquiring a federal contractor is the transfer of its contracts to the new owner. Thought the Anti-Assignment Act generally prohibits the transfer or sale of government contracts the FAR establishes novation procedures where the government will consent to the transfer. When federal contracts are transferred as part of the sale of all or substantially all of the company’s assets to another entity the government may consent if the new entity has the capability to perform, has required security clearances and other applicable qualifications and hast he ability to assume all obligations under the contract.
Where the government consents to a transfer, a novation agreement is signed by the buyer and seller and the government formally recognizes the buyer as the successor-in-interest to the contracts.
The novation process can be burdensome. It can take months to complete depending on the number of contracts and capabilities of the government agency. Usually the acquisition must be made before the novation request is made so the purchase agreement needs to make certain that the successful novation of the contracts is a condition to the closing where, if unsuccessful, the buyer can rescind the transaction or, at a minimum, reduce the purchase price.
Under a stock acquisition, a novation of contracts is not required. This is because a stock acquisition means there is a change in ownership of the company rather than a transfer of the contract to a new entity. Thought his is often more attractive, it is common following a stock acquisition for the seller to become a wholly owned subsidiary of the buyer where when the two companies are merged, the novation requirement will be triggered when the new contracts are transferredto the newly merged entity. In such cases, the novation process is not avoided.
Pending proposals are typically transferred to a buyer without difficulty provided they are transferred as part of the business sale and the transfer is to a legal entity which is the complete successor-in-interest. The parties need to promptly notify the contracting agency of the transaction so the agency can confirm the buyer is a true successor-in-interest. (Editor’s Note. Timing of transactions needs to be carefully considered. One of us was a CFO of a company on the verge of winning a $100million contract partly because of our association with our large parent company. A day before announcement of the award we had to notify the government of our impending sale to a smaller company which resulted in our loosing the contract, negating most of the benefit of the sale.)
An acquisition raises additional issues for small businesses and 8(a) companies where the buyer needs to determine whether the combined entity, together with other affiliates that may exist, will still fall into the small business size standards of the relevant NAICS codes. (See our article on small business affiliation rules in the 4Q09 issue of the DIGEST). In the case of 8(a) firms, the SBA generally prohibits the transfer of8(a) contracts to another firm no matter if they are structured as an asset or stock deal. Some waivers are permitted but they are quite limited so it is wise to pursue a waiver prior to any closing of the transaction unless there is a formula to reduce the price in case the contracts are not transferred. Also, if the buyer is an 8(a) firm, only the buyer can obtain8(a) contracts, not the new subsidiary. Consequently, if an 8(a) firm wants to use the newly acquired company in the performance of 8(a) contracts it will typically merge the subsidiary into the parent.
Structuring the Deal
Choose the form. The first step to offering a deal is to decide on the preferred form of acquisition –merger, stock exchange or consolidation which comes down to a stock versus asset transaction. Generally, buyers tend to choose the asset route because of favorable tax treatment (too far afield hereto discuss). Another factor to consider is assumption of liabilities which also favors an asset purchase. From an administrative point of view a stock transaction is usually more simple because (1) it avoids complexities involved in transferring title of real and personal assets to the new entity and (2) most contracts of the seller (e.g. teaming arrangements, subcontracts) are not easily transferred quickly without consent of all parties.
Reduce buyer risk. When a buyer acquires the stock of a company it inherits all the liabilities of the company whether known or not. Therefore the due diligence process must be thorough. In addition to extensive due diligence other ways of reducing risk for the buyer is (1) include specific representations in the purchase agreement regarding the condition of the seller and (2) require the seller to indemnify the buyer if any representation or undisclosed liability arises after the close. It is quite common to hold back or escrow a portion of the price for a period of time (e.g. one year) to apply those funds to any surprises.
Letter of intent. A letter of intent – expression of desire to sell – should have a clear statement the terms are non-binding. The letter of intent is typically signed early, well before much due diligence has occurred, so the buyer wants to make sure they can restructure or even walk away from the deal. Make sure a lawyer carefully reviews the letter.
Compliance Related Considerations
When evaluating the company, usually during the due diligence phase, certain aspects of the sellers’ contract work needs to be examined to ensure there are no surprises. Areas that we commonly examine include:
1. Valuation of Backlog. The variations of government contracts make assertions about contract backlog problematic. For example, use of IDIQ, Multiple Award Schedule and Blanket Purchase Agreement contracts does not obligate the government to purchase significant items or services. Though these contracts may be awarded with great fanfare and large dollar amounts announced, they often only provide the contractor with the right to compete for future orders and those orders may never be funded. What really counts when assessing a seller’s backlog is the receipt of funded orders. Hence the buyer needs to carefully examine orders actually received under IDIQ, MAS and BPA vehicles when conducting due diligence of seller’s backlog with particular focus onthe amount of funding, terms and scope of the orders.
2. Claims & Terminations. The buyer needs to assess all existing claims, potential claims and termination settlements and estimate the likelihood of recovery. In our due diligence, we have found many circumstances of exaggerated assertions of potential recovery. We have also encountered the opposite circumstances where though the seller did not identify any potential claim and termination benefits, our close examination of the likelihood of certain recoveries provided a significant source of unexpected value to our buyer client that was later realized.
3. Cost Allowability/Indirect Rate Submissions. Other than firm fixed price contracts (though defective pricing audits can adjust prices paid), there can be significant retroactive adjustments to interim billing and forward pricing rates based on audits of the contractor’s actual incurred costs experience for a given year. The amounts of these readjustments are not often clear at the time of a buyer’s due diligence efforts resulting in potential time bombs in the future. Incurred cost proposals for relevant years may not have been prepared. If prepared, they may not havebeen audited. If audited, the rates for a given year may not have been settled, where the contractor, government auditors and contracting representatives may be in the middle of resolving numerous questioned cost issues. If settled, the seller may have(inadvertently or not) not disclosed the results and the impact on relevant contracts and subcontracts.The due diligence efforts need to identify the potential liability of these potential time bombs. An estimate of liability needs to be taken. For example, at the very least, the buyer may want to ascertain the seller’s historical experiences (e.g. ratio of billed to settled costs), adequacy of financial reserves, etc.
In addition to the quantitative issues discussed above, the protection of the seller’s intellectual property needs to be evaluated. A contractor doing business with the government needs to exercise considerable care to assure it does not grant an “unlimited rights” license to the government for its technology or other assets. Such a license could entitle the government to give the design - either in the form of technical data or computer software code - to other companies and to authorize those companies to copy and sell the product illustrated in the data or code to any customer, anywhere. On the other hand, a contractor that developed its intellectual property at private expense or, to some degree, not at government or public expense can protect it, the company’s policies related to protecting its intellectual property and the status of its intellectual property, especially if the seller’s proprietary technology accounts for a significant share of its value, needs to be examined during a due diligence.
© 2024 Government Contract Associates. All Rights Reserved.
