Commentary

GovCon M&A benefits and pitfalls

It can be simpler in some ways compared to starting a contracting business from scratch, but there are M&A considerations regarding culture fit and valuation.

Michelle Jenkins, CPA, MBA

August 1, 2024 5:16 pm

4 min read

Companies entering into government contracting (or expanding their capabilities team skillset) may consider a mergers and acquisition strategy. They can merge with or acquire another contractor to gain past performance history, new contract vehicles and new technical capabilities.

It can be simpler in some ways compared to starting a contracting business from scratch. However, there are the usual M&A considerations regarding culture fit and valuation. Then there is another layer of contract terms and regulations inherent in government contracting.

While government contracting is a way to diversify revenue in a company and enjoy guaranteed payors, the complexity of compliance and reporting as well as talent retention must be considered in the overall costs of purchasing a contractor.

Should you pursue M&A?

In general, M&A is a big consideration on the buyer side and the seller side. I often hear from small contractors that they weren’t considering a sale until a buyer approached them. The transaction takes time and energy and money for both parties. For founders who have grown a company, there is also the emotion involved with their team and their personal transition. They want to make sure that the deal benefits their people as much as themselves.

For the buyer, there should be a strong business case for acquiring the contractor. Will the merger or acquisition add capabilities that the acquirer does not have? Is the profit margin from the contracts worth the transactional costs? Are relationships good with the government contracting officers or could this transaction result in a rebid for convenience?

There will be negotiations to retain key employees named on existing contracts, minimizing the risk of losing those contracts but also retaining critical knowledge, relationships and skills. What will it take to secure key employee loyalty and high performance?

With all of these considerations satisfied, the structure of the transaction also impacts whether or not the government recognizes the successor (the buyer) for existing contracts.

Is novation necessary after M&A?

A contractor merging with or being acquired by another company may be tasked with a novation process to transfer contracts to the acquirer or new entity. Both parties should anticipate at least some novation factors impacting their final agreement.

The Federal Acquisition Regulation offers a checklist for walking through the applicability of novation agreements and the extensive documentation required. If the transaction is a stock sale, and all assets and liabilities remain under the control of the original contracting party (e.g., subsidiary), then buyers may avoid novation.

However, FAR states that “whether there is a purchase of assets or a stock purchase, there may be issues related to the change in ownership that appropriately should be addressed in a formal agreement between the contractor and the government.”

The contracting officer should be notified of the sale and may want to rule out any conflicts of interest with the acquiring company. Barring that, the officer may require disclosure of things such as long-term incentive compensation plans or any history of noncompliance by the contract successor.

There is a risk that the new owner may lose certain contracts at recompete, so that risk will be weighed and considered when looking at a purchase price. At-risk contracts (or contracts that will be up for recompete) may also affect the final valuation and outcome for the seller and the contracting team.

Confirm set-aside terms in contracts

If the seller’s contracts have any set-aside awards through the Small Business Administration, they can be at risk through M&A. A stock purchase and subsidiary structure is a potential solution if you can operate it as its own company, and as such, only the company with the small business classification will apply. Navigating this restructuring with the purchase is important to ensure that you don’t put any of the small business certifications at risk.

This is a good strategy only if the contract has a long-term value for the buyer. As mentioned earlier, the buyer may want access to a new area of contracting or is pursuing a new business vision.

What is your business vision?

There are nonfinancial reasons for pursuing government contracting. Companies are supporting public/private innovation and helping the U.S. government conduct missions that support the country. This may be in science, health, transportation, energy, space exploration, defense, cybersecurity or other endeavors.

Despite the hurdles and risks, exploring the right M&A opportunity can create a stronger government contracting industry. Work with your advisors to make sure that the end result benefits the buyer, the seller and the government client for a win-win-win.

Michelle Jenkins, CPA, MBA, is a partner with Anglin Reichmann Armstrong, with offices in Alabama and Florida. She leads the business solutions team for government contracting clients.