The U.S. Small Business Administration (SBA) Office of Hearings & Appeals (OHA) recently held that an entity may be affiliated with another entity solely because it holds a very small minority ownership interest (less than 1%) in that entity. OHA’s ruling is noteworthy because under the SBA’s rules, the employees or revenue (depending on the NAICS code) of a concern and its “affiliates” must be aggregated when determining a small business concern’s size and eligibility for small business set-aside contracts. The decision should disabuse contractors and investors alike of any perception that very small minority ownership interests cannot give rise to affiliation.
Entities are considered affiliates under the SBA’s rules if one controls or has the power to control the other, or if a third party or parties controls or has the power to control both. It is well-established that one entity does not need to have controlling share of stock ownership (above 50%) in another for the two entities to be deemed affiliates under the SBA’s rules. However, some government contractors might believe that a very small minority ownership interest cannot create affiliation. OHA’s decision in Melton Sales & Service, Inc., SBA No. SIZ-5893 (Mar. 29, 2018) (Melton) confirms that such belief is mistaken.
In Melton, an unsuccessful offeror in an Army procurement protested the size status of the awardee, MTP Drivetrain Service, LLC (MTP). The protester contended that one of MTP’s affiliates, Joe Gear Holdings, LLC (Joe Gear), was also affiliated with VIPAR Heavy Duty Inc. (VIPAR) in part because Joe Gear was one of 120 stockholders that each held one voting share in VIPAR (an approximate 0.8% interest). The protester argued that because Joe Gear was affiliated with VIPAR, and MTP was affiliated with Joe Gear, that VIPAR was affiliated with MTP and that VIPAR’s employees should be counted when determining MTP’s size. OHA agreed, noting that Joe Gear was one of multiple minority shareholders in VIPAR whose investments were equal or approximately equal in size, and therefore there was a rebuttable presumption that each minority shareholder controlled VIPAR. OHA relied on the following SBA regulation at 13 C.F.R. § 121.103(c)(2):
If two or more persons (including any person, concern or other entity) each owns, controls, or has the power to control less than 50 percent of a concern’s voting stock, and such minority holdings are equal or approximately equal in size, and the aggregate of these minority holdings is large compared with any other stock holding, SBA presumes that each such person controls or has the power to control the concern whose size is at issue. This presumption may be rebutted by a showing that such control or power to control does not in fact exist.
Critically, OHA stated that the presumption that each minority shareholder controls an entity “may be rebutted with evidence to the contrary, such as evidence demonstrating another party such as the Board of Directors and CEO or President controls the concern,” but that absent “clear evidence demonstrating control or the power to control by another party, it is presumed that each minority shareholder has equal control over the subject concern, regardless of the size of the shareholder’s interests.” OHA also described the inability of any one of the 120 stockholders to individually exercise actual control over the entity as “immaterial” to the affiliation analysis. Because MTP in Melton did not establish that any party other than the 120 stockholders controlled the entity, it failed to rebut the presumption of affiliation.
OHA’s ruling in Melton did not impact the awardee’s eligibility for the contract award because affiliation with VIPAR did not push MTP above the size standard threshold that applied to the procurement. In many circumstances, however, affiliation with other entities can render a contractor ineligible for small business contract awards. Small business contractors doing deals therefore should be cautious in deciding how to structure minority investments in other entities. An investment may not make strategic sense if it results in the business being determined ineligible for small business contract awards. Similarly, private equity groups and other parties seeking to invest in small business concerns should be careful when structuring such investments because a minority investment that appears to give the investor no actual control over the company could be sufficient to create affiliation between the concern and the investor.
The authors are available for questions. The Government Contracts Practice at Hogan Lovells helps advise companies that may have questions concerning SBA regulatory implications of transactions with small business contractors.