Losing Small Business Status at the Letter of Intent Stage: The Perils of the SBA Present Effect Rule in Small Business M&A

Most people in the mergers and acquisitions arena are aware of the Small Business Administration’s (SBA) recertification rule that applies in the event of a merger with or acquisition of a small business government contractor. If, after an acquisition closes, the aggregate size of the small business target and its new owner or affiliate is above the applicable size standard, the small business must recertify itself as other than small.

However, the recertification rule is not the only SBA rule triggered by merger or acquisition activity. Under SBA’s “present effect” rule, a target company’s small business status may be altered prior to the closing of a deal by the mere execution of a letter of intent or similar event.

1. What is present effect? Why does it matter?

SBA determines the size of a company by calculating either the revenues or employee count of the company, inclusive of its affiliates. SBA determines that two entities are affiliated if one entity has the power to control the other.

In this regard, SBA considers stock options, convertible securities and agreements to be acquired as having a “present effect” on the power to control a concern. In determining the size of a concern and whether it is affiliated with other entities, SBA treats outstanding options and convertible securities as if they had already been exercised. The existence of an agreement to be acquired, such as a letter of intent (LOI), memorandum of intent or even an oral agreement, could result in a finding of affiliation between the target company and the purchaser using the present effect rule.

The size status of a small business bidding on or holding small business set-aside contracts could be jeopardized by a finding of affiliation. If affiliation is established, the small business's eligibility for set-aside contracts pending award, as well as its ability to receive task order awards under certain multiple award contracts, could be negatively affected while the affiliation continues. In recent years, several protests of small business contract awards have been sustained on the basis of the affiliation of the small business with a potential acquirer prior to the award of the contract. Typically, this affiliation has been based on a LOI or similar agreement or understanding between the small business and a buyer.

2. When is a letter of intent or similar agreement given present effect?

SBA gives present effect to an agreement to merge or be acquired if it is an “agreement in principle.” The determination of whether an agreement is an “agreement in principle” is based primarily upon the stage of negotiations between the parties and the specificity of the agreement’s terms. Agreements solely to begin or continue negotiations toward the possibility of a merger or a sale of stock at some later date are not considered agreements in principle and are therefore not given present effect by SBA. However, if “there is supporting evidence to show that serious negotiations between the parties have occurred, letters of intent and similar documents will be given present effect …” WRS Infrastructure and Environment, Inc. v. US, 85 Fed. Cl. 442 (2009) (citing Size Appeal of PCCI, Inc., SBA No. 4531 (2003)).

Because the stage of the negotiations toward an acquisition is often reflected in the terms of the agreement, SBA focuses on the agreement’s terms to determine whether it is an “agreement in principle” to which the present effect rule applies. For example, in the WRS Infrastructure case, the Court of Federal Claims focused upon a few primary points in concluding that the present effect rule applied to a LOI executed after the submission of proposals for set-aside contracts but prior to award. First, the agreement was signed by both parties and expressed the intent of the buyer to purchase all of the outstanding stock of the target company. Second, the agreement indicated that the buyer had already conducted several weeks of due diligence on the small business target. Although the parties to the transaction argued that additional diligence was conducted after the letter of intent was signed, the Court determined that this confirmatory due diligence did not affect the fact that the LOI “set forth the essential terms of the agreement” based on the prior due diligence. Finally, the LOI contained the exact purchase price for all of the outstanding shares of stock, target delivery dates for the stock purchase agreement, the closing date and other specific transactional dates and amounts.

The WRS case should be contrasted by the decision of the SBA’S Office of Hearings and Appeals (OHA) in Size Appeal of Refiner’s Marketing Company. In that case, OHA ruled that a non-binding “memorandum of intent” should not be given present effect.¹ SBA No. 1796, 1986 LEXIS 96, (Sept. 22, 1983). OHA cited to the lack of a definitive purchase price and the fact that the parties continued to negotiate on price after the LOI was signed as a key factor in its decision. In addition, the target company continued to engage in negotiations with other firms despite the memorandum of intent. Based on these factors, OHA determined that the memorandum of intent was not an agreement in principle and therefore should not be given present effect.

In considering the practical application of the present effect rule, the devil may well be in the details. A statement of the parties' intentions regarding the purchase price, closing dates and other similar terms are often necessary to attract and retain buyers or sellers, and to convince the parties to negotiate exclusively with each other for a period of time toward a transaction. Often, these terms are heavily negotiated prior to execution of the LOI, particularly if there is an extensive bidding process for a target. Further, even if a LOI is, by its express terms, non-binding, it often provides the basis for many of the material terms of the definitive transaction agreement. Thus, creating and executing LOIs and other similar documents without including the salient terms of the definitive agreement, such as price, is impracticable in most transactions.

It might appear that the solution is to simply execute the LOI subsequent the target company’s self certification on a pending procurement.² SBA is mindful, however, that negotiations towards an acquisition frequently occur prior to the execution of a LOI. If it is clear that a verbal agreement has been reached and a written document is merely a formality, SBA would apply the present effect rule. See Size Appeal of Technology Systems Associates, Inc., SBA No. 3963 (1994) (present effect rule would not apply where there was no evidence of formal agreement or even a “meeting of the minds”).

3. Exceptions to the present effect rule

While the determination of whether an “agreement in principle” exists is based upon the terms of the applicable document, certain terms may also preclude application of the present effect rule. There are exceptions to the present effect rule that apply despite the presence of an agreement in principle. SBA will not give present effect to an agreement, option or convertible security if (1) it is subject to a condition precedent that is “incapable of fulfillment, speculative, conjectural, or unenforceable under state or Federal law” or (2) there is a low probability that the transaction would be consummated or the rights exercised.

SBA has interpreted these exceptions very narrowly and is cautious of companies trying to create ambiguity where there is none. For example, contingencies or conditions to closing that are avoidable at the discretion of either party would not prevent application of the present effect rule. Size Appeal of Consolidated Industries Inc., SBA No. 4235 (1997) (present effect rule applied to option agreement where option holder could choose to avoid the occurrence of the preconditions to the option). OHA has also held that regulatory constraints, including the requirement to obtain approval for the transaction, do not render the closing of the deal or exercise of the option a speculative event. Size Appeal of Intercontinental Manufacturing Co., SBA No. 3879 (1994) (insurance regulations that provided disincentives to exercising option were merely a deterrent within the option holders control, and did not indicate that the option was unlikely to be exercised).

The few cases where the above exceptions have applied involved clearly speculative or conjectural events or conditions, such as triggering events reliant upon extremely high or extremely low dollar values, or events which would result in a loss to the option holder. Size Appeal of Airdrome Parts Co., SBA No. 3922 (1994) (present effect rule did not apply because possibility of exercise of warrant was remote when warrant exercise price was higher than the present value of the stock); Size Appeal of Horizons Technology, Inc., SBA No. 3591 (1992) (present effect rule did not apply where option to convert stock was based upon several contingencies including occurrence of redemption events within specific time frame and undefined option price); Size Appeal of SRS Technologies, SBA No. 3180 (1989)(option exercisable only in the event the firm sustained a decrease of $20 million in net worth was speculative, conjectural and beyond control of option holder).

Conclusion

Both buyers and sellers involved in an acquisition of a small business must be extremely mindful of the potential application of the present effect rule from the earliest stages of a transaction. Small business contract awards during the period leading up to a transaction may be jeopardized by a finding that the small business target was affiliated with another business prior to the award. Buyers and sellers should carefully scrutinize any pending small business awards prior to entering into substantial discussions and/or letters of intent or similar agreements. It is also important for buyers and sellers to work with experienced legal counsel in structuring the transaction, and if possible, the LOI, to minimize the dangers of the present effect rule.

¹ Parties in present effect cases have argued that a non-binding agreement cannot be an agreement in principle. Yet as the WRS case explains, the fact that an agreement is “non-binding” is not determinative and even LOIs that expressly contain non-binding material terms may still be considered an agreement in principle. WRS Infrastructure and Environment, Inc. v. US, 85 Fed. Cl. 442 (2009); Size Appeal of Kadix Systems, LLC, SBA No. 5016 (2008) (present effect rule applied despite language referring to document as non-binding).

² SBA determines the size of an entity on the date it submits its final offer inclusive of price, and offerors are required to self-certify as to their size on that date. A target company that submits its offer and self-certification prior to execution of the LOI remains eligible for award, unless the contracting officer requests any additional self-certifications prior to award.