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While much of the business news discussed in major periodicals deals with large corporations – from quarterly earnings reports, to initial public offerings, to the nuances of our international tax system and the like – of far greater consequence to our economy are the thousands of small businesses creating jobs across the country. Indeed, two-thirds of all jobs created in 2014 were created by small businesses. And for those businesses benefiting from government programs supporting small business, it’s important to remain “small” in the eyes of the government.

The SBA and Thresholds for Size Determinations

In 1953, the federal government created the U.S. Small Business Administration (SBA) to help small businesses grow and thrive. It does that primarily by providing access to capital, entrepreneurial development, preferential government contracting and advocating for small businesses. To access SBA assistance, a “small” business must be beneath certain thresholds as determined from time to time, which are assigned based on North American Industry Classification System (NAICS) codes. “Small” for purposes of SBA is a measure of either a company’s average annual receipts or the average number of employees.

For example, SBA categorizes soybean farmers with an NAICS code of 111110 generating less than $750,000 in average annual revenue as small. But family clothing stores with an NAICS code of 448140 can take in revenue up to $38.5 million annually and still is small for SBA purposes. Employee limitations can range from 50 employees (for fuel dealers with an NAICS code of 454310) to 500 employees (for dog and cat food manufacturers with an NAICS code of 311111) to 1,500 (for ammunition manufactures with an NAICS code of 332993). It is, therefore, vital that companies receiving assistance from SBA understand these limitations especially if their business models rely heavily on government contracting.

“Affiliation” Between Small and Large Businesses

But even objectively small companies by comparison – either because of their modest annual revenue or their number of employees – must be wary of a specific principle that could undermine their business: affiliation. The basic idea is that if a small company is, for all intents and purposes, nothing but a legal fiction of a large company, SBA could issue an adverse size determination, thus denying the small company the preferable treatment from which small businesses benefit. The most obvious examples of affiliation deal with management of the business – such as companies that share the same officers or directors – and ownership structures.

It’s understandable that SBA would issue adverse size determinations to deny preferential contracts to the playthings of large conglomerates. But unbeknownst to many small business owners, the affiliation concept of “economic dependency” has the potential to upend their businesses overnight. The theory is that if a small business is so dependent on the significant revenue it derives from one large company, the revenue from both can be aggregated and imputed to the small company, in which case the SBA could determine that the small company is “other than small” and revoke the benefits it receives; that can be fatal for small businesses who depend on subcontracts with large government contractors.

The 70 Percent Rule

The relevant portion of the regulation is “economically dependent through contractual or other relationships” – a suspiciously vague wording that lends itself well to varying interpretations. In Size Appeal of Faison Office Products, LLC. (SBA No. SIZ-4834), SBA determined that a certified small company receiving at least 70 percent of its revenue from one large company was “economically dependent” on the latter and issued an adverse size determination. But, importantly, while SBA held that 70 percent was dispositive as a matter of law, it left open the possibility of finding economic dependency where the small business received a much smaller portion of its revenue from one large company:

In making this holding, I am not fixing a certain percentage of revenue as being sufficient to prove economic dependence, for it could be as low as 30% or 40%, based upon the facts. However, I do hold, as a matter of law, that when one concern depends on another for 70% or more of its revenue, that the concern is economically dependent on the other. Given the high probative value of this kind of evidence, the only exception to this holding would be if the dependent concern could prove, by clear and convincing evidence, that its interests are separate from the other concern.  

It is also noteworthy that SBA takes a totality of the circumstances approach to its size determinations and may aggregate numerous factors, each of which individually hold little sway but when taken together lead to an adverse determination. For example, in Faison Office Products, aside from developing the 70 percent rule, SBA also highlighted the fact that the parties marketed themselves as having a “strategic alliance.” Customers could claim they were supporting a minority-owned business by ordering product from the large company because of the subcontract it had with Faison.

After an Adverse Size Determination

As a consequence of an adverse size determination, companies cannot self-certify as a small business (or face criminal action if they do) in order to receive SBA assistance. To comply with that directive, they must update their System for Award Management (SAM) profile to reflect the change. Additionally, if there are outstanding contracts previously issued based on the company’s small business status, the company must immediately notify the officials responsible for the contract.

All is not lost, however, since companies may petition SBA to be re-certified as small. The process seems relatively straight forward: the company can re-apply at any time without using a specific form for the application. But, in order to make a compelling case, it is essential that the company rectify the various aspects that led to the adverse determination in the first place. And for purposes of “economic dependency” under Faison Office Products, a small business would be well advised to diversify its client base to prevent generating 70 percent of its revenue from one source.

To learn more about Dillon S. Nichols and his practice, please visit his profile.