Minority Investment Tips to Preserve Small-Business Status
Small business set-aside contracts awarded under the Small Business Act remain a huge part of federal procurement spending — the U.S. government awarded $120.8 billion[1] in federal contract dollars to small businesses in 2018 alone — up 33% from 2015.
Yet the U.S. Small Business Administration's regulations limit the ability for small businesses to remain eligible for new set-aside contracts following significant outside investments. The biggest limitation on outside investment is the rule that ownership or control of 50% or more of the voting stock of a small business concern creates a per se, unrebuttable presumption of affiliation between the concern and the majority equity holder.[2]
This limits parties seeking to preserve new set-aside opportunities to structuring minority investments. However, many of the protections minority investors seek — common in commercial transactions — also run afoul of the SBA's small business size-status rules and can jeopardize future small business set-aside awards.
This article examines key pitfalls and provides pointers that small businesses and their investors should keep in mind in structuring minority investments, balancing the twin goals of preserving the small business concerns’ eligibility for new set-aside contracts and the minority investors desire to protect their investment.
Size Status and Affiliation Overview
To determine whether an entity qualifies as a small business, the SBA typically counts the entity’s receipts or employees, plus those of the entity’s affiliates. Affiliation exists when one entity controls or has the power to control another, or when a third party controls or has the power to control both entities.
Control can be affirmative (an entity can direct the actions of another entity) or negative (an entity can block important functions of another entity). Control may arise through ownership, such as when a person owns a majority, plurality, or a relatively significant percentage of the entity’s voting stock; management rights; or other relationships or interactions between the parties. In short, evaluating affiliation risks requires a case-by-case assessment.
Outsized Minority Interests Where There is No Majority Owner
Some investors believe — incorrectly — that if they do not have a majority or plurality of the voting shares in a small business, then they do not control that business and cannot be affiliates. But the SBA applies what is known as the minority shareholder rule, where if a small business has multiple owners with roughly equal minority voting interests, all of those owners are presumed to control the small business.
Avoid Similar Ownership Interests and Use Nonvoting Stock
To avoid affiliation where there is no majority owner, a minority investor must not hold an interest that is equal or approximately equal in size to one or more other minority shareholders.
As a rule of thumb, a qualifying interest should be 10 percentage points lower than other minority shareholders (e.g., in a concern with the largest investor holding 40% of the voting interests, a minority investor should hold no more than 30% of the remaining voting interests to avoid triggering the minority shareholder rule).[3]
Instead of acquiring a significant voting interest in a small business (and risk triggering the SBA's regulations), investors should consider nonvoting stock or some other vehicle that does not affect the ownership interests in the small business.
Importantly, the SBA looks at voting power when determining who controls the small business. The SBA's Office of Hearing and Appeals has further confirmed this principle by acknowledging that “[o]wnership of nonvoting stock does not confer power to control on its owner, absent some provisions that give the owner that power.”[4] In short, nonvoting shares are an effective tool to minimize affiliation.
Impermissible Negative Controls
Even if a concern does not have an outsized minority investor, affiliation may exist if the minority investor can exercise negative control. Negative control arises when the minority investor can “block ordinary actions essential to operating the company.”[5] Examples of ordinary actions include (1) the creation of debt,[6] (2) the payment of dividends,[7] (3) hiring, terminating, or changing the compensation of executive officers,[8] or (4) preventing a quorum or otherwise blocking actions by the board of directors.[9]
Limit Minority Rights to Extraordinary Actions
Although minority investors cannot exercise control over the day-to-day operations of the business, reasonable investor protections remain permissible. The SBA recognizes that minority owners may protect their investments by blocking certain extraordinary actions of the small business as long as the investors do not impede the majority’s ability to control the operations of the business.[10]
Examples of such extraordinary actions include the authority to block (1) the sale of all or substantially all of the assets of the company,[11] (2) the dissolution of the small business concern,[12] (3) entering into a business substantially different from the business the company is currently engaged,[13] (4) accepting additional capital contributions from a member,[14] (5) admitting new members,[15] (6) amending the business’s operating agreement in a manner that materially alters the rights of existing members,[16] or (7) filing for bankruptcy.[17]
Common Investments with Other Small Business Investors
Affiliation can arise if an investor has other common investments apart from the small business. If two or more investors share common investments that are either substantial in number or substantial in total value, then the investors’ interests in the small business will be aggregated, which in turn could create an affiliation.[18]
With respect to private equity investors, the SBA's Office of Hearing and Appeals has found an identity of interest among private equity funds where those funds shared as few as three common investments.[19]
Screen the Small Business’s Other Investors for Common Investments
Minority investors should review common investments shared with the small business’s other minority investors. If any two minority investors share more than one common investment, or the common investment constitutes a significant portion of the minority investor’s portfolio, then further review should be conducted to determine whether an identity of interest affiliation exists, and whether the affiliation would threaten the company’s small-business status.
Reliance on (Illusory) Bright-Line Rules
As reflected above, though there are many ways to make (and protect) minority investments, there are unfortunately no bright-line rules to avoid affiliation. Whether an investment will create affiliation risk that may jeopardize future small business set-aside awards depends on the specific terms of (and parties to) that investment.
Carefully Review Proposed Investments and Investors
Unfortunately, the SBA’s regulations regarding small business investments are complex and often fact intensive. Small businesses and their investors should consult with advisers with small-business investment experience early in the process. This will help promote the timely assessment of potential investment strategies and their impact on small business program eligibility.
“Minority Investment Tips to Preserve Small-Business Status,” by Justin Chiarodo and Michael Montalbano was published in Law360 on March 26, 2020.
[1] www.sba.gov/about-sba/sba-newsroom/press-releases-media-advisories/federal-government-achieves-small-business-contracting-goal-sixth-consecutive-year-record-breaking.
[2] 13 C.F.R. § 121.103(a)(1).
[3] See Size Appeal of The Woods Hold Group Inc., SBA No. SIZ-5009, at 7 (2008) (finding that shareholder with 45.96% interest was not approximately equal to shareholder with 36.62% interest); Size Appeal of Forterra Sys. Inc., SBA No. SIZ-5029, at 8 (2009) (finding that shareholder with 28.7% interest was not approximately equal to shareholder with 17.3% interest).
[4] Size Appeal of Native Energy & Tech. Inc., SBA No. SIZ-5249, at 10 (2011).
[5] Size Appeal of Southern Contracting Solutions III LLC, SBA No. SIZ-5956, at 10 (2018).
[6] Size Appeal of Team Waste Gulf Coast LLC, SBA No. SIZ-5864, at 7 (2017).
[7] Id.
[8] Size Appeal of DHS Systems LLC, SBA No. SIZ-5211 (2011)
[9] Size Appeal of Environmental Restoration LLC, SBA No. SIZ-5395, at 7 (2012).
[10] Size Appeal of Southern Contracting Solutions III LLC, SBA No. SIZ-5956, at 10 (2018).
[11] Size Appeal of S. Contracting Sols. III LLC, SBA No. SIZ-5956, at 12 (2018).
[12] Size Status of Carntribe-Clement 8AJV # 1 LLC, SBA No. SIZ-5357, at 15 (2012).
[13] Size Appeal of EA Engineering, SBA No. SIZ-4973, at 3 (2008).
[14] Size Appeal of Dooleymack Government Contracting LLC, SBA No. SIZ-5086, at 7 (2009).
[15] Id.
[16] Id.
[17] Id.
[18] Size Appeal of Tesecon Inc., SBA No. SIZ-5985, at 6 (2019).
[19] See Size Status of Erickson Helicopters Inc., SBA No. SIZ-5704 at 5-6 (2016); see also Size Status of ACELRX Phams. Inc. , SBA No. SIZ-5501 (2013).