Opportunities for Small Businesses in the Government Market

The US Government is the single largest purchaser of goods and services in the world, and its annual goal is to award 23% of its prime contract dollars to small businesses.  For fiscal 2018, that amounted to over $120 billion in small business prime contracts.  Federal agencies accomplish their small business contracting goals in part through mandatory small business “set-asides.”  If an agency contracting officer determines that at least two small businesses are capable of providing a required product or service at fair market prices, then regulations require that the contracting officer set that opportunity aside for award to a small business.  US Government prime contractors also have small business subcontracting goals, implemented through mandatory small business subcontracting plans.  State and local governments, too, have small business contracting goals, preferences, and set-asides.

The US Government also funds R&D through special programs reserved for small businesses.  One of the better known and successful of these is the Small Business Innovation Research (“SBIR”) program, the purpose of which is to promote technological innovation and incentivize commercialization of that technology.  Eleven federal agencies participate in the SBIR program, including the Departments of Defense, Energy, Education, Health and Human Services, and Homeland Security, as well as NASA and the National Science Foundation.

So opportunities abound for emerging companies to sell their products and services to government customers, directly and indirectly, and to take advantage of available federal funding to develop and enhance their technology.  But the government is not just another customer or business partner, and it’s important to understand some of the more significant differences (and related risks) between government business and commercial business.

Unique terms and conditions and socioeconomic obligations

Government contracts contain unique terms and conditions covering areas like equal opportunity and affirmative action for various categories of employees and prospective employees, related reporting and internal communication requirements, preferences and/or requirements for domestically manufactured products (which can include software), record-keeping requirements and government audit rights that survive for years past final payment, and various business ethics requirements (for example, prohibition of kickbacks and gratuities to government personnel, lobbying restrictions and potential reporting obligations, and disclosure obligations for organizational conflicts of interest).

Small business eligibility rules and certification requirements

Small business eligibility is contract-specific, and is measured based upon the contractor’s number of employees or its annual receipts, depending on the size standard that applies to the particular contract.  Regulations of the US Small Business Administration (“SBA”) establish those size standards for different industry classifications, and define terms that must be understood before your company certifies its eligibility as a small business.  The most important such term is “affiliation.”  To determine size status, the SBA will combine the employees or receipts of the contractor and all of its affiliates.  This means that a company with significant outside investors can be a “large business,” ineligible for government small business programs and set-aside contracts, even if it has few employees and little revenue of its own.

Allocation of rights in IP and specific marking requirements

Federal agencies typically acquire a broad license in IP that they acquire or help develop through R&D funding, but they are not entitled to “ownership” — i.e., the right to exclude the contractor from future commercial use of that IP.  The allocation of rights between the contractor and the government is accomplished largely through standard contract clauses that are subject to negotiation and, among other things, require specific markings on technical data and software delivered to the government.  Failure to mark deliverables as required by the contract can result in the government acquiring broader rights than it otherwise would have.

Enhanced risk for noncompliance

Failure to comply with government contract terms and conditions or making inaccurate certifications can result in liability far more significant than customary breach damages in a commercial contract.  In some circumstances, non-compliance and false certifications can lead to alleged violations of the False Claims Act, financial penalties that exceed the value of the contract, suspension and debarment (i.e., an administrative remedy for the government that prevents the company from doing business with any government agency), or even criminal liability.  When these types of issues arise in a funding or M&A transaction, they can have consequences for the valuation and marketability of the company.

Companies can minimize the most significant risks associated with government contracts by paying attention on the front end to contract administration and compliance processes.  Companies that do so can position themselves to win government contracts and increase revenue while minimizing threats to value.