This is the second in a series of three articles brought to you by Maria L. Panichelli and Edward T. DeLisle for GovBizConnect, an online professional network for government contracting professionals. 

Originally published on the GovBizConnect website.

Welcome to the second installment of our three-part series, Key Considerations in Small Business Teaming: How to Form a Productive Partnership While Safeguarding your Interests and Protecting your Small Business Eligibility. You can read Part I here. Today, we will be focusing on how to avoid common pitfalls in teaming. But check out our previous installment on the differences of teaming and joint venturing, and stay tuned for our final installment, which will address how to draft an enforceable teaming agreement that will protect your interests as a small business.

Teaming is one of the hottest topics in Federal contracting – and for good reason. Whether you are a small business looking to expand your capabilities, or a large business looking for access to set-aside contracts, teaming can greatly expand your federal contracting opportunities. However, though teaming is often talked about, it is just as often misunderstood. This is problematic because, when done incorrectly, teaming can cause a host of issues, all of which have very serious consequences. For small businesses in particular, there are significant risks. Improper teaming can adversely impact small business status, rendering a small business contractor ineligible for future set-aside contracts. For those reasons, it is critically important that small business contractors be educated as to the most common pitfalls relating to teaming. This article seeks to do just that. We will focus on two key problem areas: affiliation, and subcontracting limitations.

What is Affiliation and How do I Avoid It?

Affiliation is a big deal, because it can impact whether a business qualifies as “small.” To determine if a contractor qualifies as a “small business” for the purposes of a given contract, the contractor must locate the North American Industry Classification System (“NAICS”) code assigned to that contract (usually found in the solicitation itself), and refer to the “size standard” associated with that code. A size standard is measured either in revenue or employees. To qualify as “small,” a concern must not exceed the dollar threshold or number of employees designated for a particular code. When two companies are found to be “affiliated,” their respective sizes (determined by either revenue or number of employees) are added together. The total is what is evaluated when determining whether the company is actually “small” based upon the SBA’s “size standards.” If the sizes of the two businesses, added together, exceed the applicable size standard, neither can be considered “small.” Accordingly, a finding of “affiliation” is something small businesses generally want to avoid.

Affiliation is governed by 13 C.F.R. § 121.103, which explains that “concerns and entities are affiliates of each other when one controls or has the power to control the other, or a third party or parties controls or has the power to control both. It does not matter whether control is exercised, so long as the power to control exists.” (13 C.F.R. 121 § 121.103(1)).

In assessing whether or not two businesses are affiliated, the SBA uses a totality of the circumstances test. That means that, while no single factor is sufficient to constitute affiliation, there are many that can impact an affiliation analysis. Indeed, when analyzing potential affiliation between two or more companies, the SBA considers a number of factors, including but not limited to ownership, management, previous relationships with or ties to another concern, and contractual relationships. In the teaming context, affiliation generally occurs in one of two ways.

First, general affiliation can occur when there is an ongoing relationship between two companies, where one business appears to control the other, or where the two companies appear too closely related or intertwined. In the teaming context, this type of general affiliation can occur if a small business repeatedly teams with the same subcontractor/teaming partner, is financially reliant on its teaming partner (as evidenced by loans, bonding support, guarantor status on LOCs, etc.), shares employees, office space, equipment, supplies, or other resources with the teaming partner, or if the small business and its teaming partner have common ownership. Common investments among owners can also cause an issue. Certain types of familial relationships, or previous employee/employer relationships are also considered to be signs of affiliation.

Affiliation can also arise from a teaming relationship on a single project. The “Ostensible Subcontractor” rule provides that a small business that “is unusually reliant” on a subcontractor will be deemed affiliated with that subcontractor for size determination purposes. In other words, a small businesses can run into affiliation problems when the small business teams with a subcontractor on a particular project, but then allows that subcontractor to control that project.

In order to determine whether the subcontractor is, in fact, in control of a given project, the SBA will look to a variety of factors, including, but not limited to: whether it is the small business prime contractor or the subcontractor that is performing the vital components of the project; whether the small business prime contractor is financially reliant on the subcontractor; whether the small business has the requisite experience or managerial capability to control the project; and whether it is the small business prime contractor or the subcontractor who is, in reality, controlling the means and methods necessary to successfully complete the project. If the subcontractor appears to be the party in control, the SBA is likely to find that the small business prime contractor and subcontractor are affiliated.

So, how do you make sure that your teaming agreement does not result in affiliation? The advice we give our clients is simple. To avoid general affiliation, make sure that you maintain a “clear line of fracture” between your company and your teaming partner. If you are going to team with a subcontractor, make sure you do not have other ties to that company. Do not invest in your teaming partner (either individually, or on behalf of your company) or allow your teaming partner to invest in your company, or any other business interests you or the other owner’s of your company might have. Don’t team with companies owned by family members, or companies at which you were previously employed. If you must team with such a company, be very careful that you do not appear reliant on, or intertwined with, that business. Loans from a teaming partner should be avoided, or at a minimum, documented to the maximum extent possible. Do not rely too heavily or regularly on a teaming partner for financial support, and avoid having another business serve as a guarantor of your credit line. Do not share things; hire your own employees, rent your own office space, and secure your own equipment and supplies. Rather than repeatedly teaming with the same company, vary it up. Team with a number of different companies, not just one. Overall, maintain corporate formalities, and ensure that all transactions with other companies are made at arms-length.

To avoid the perils of the “Ostensible Subcontractor” rule, maintain control over your company and every project on which you are the prime contractor. You may enter into subcontracts, but make sure that you retain control over how the subcontract is performed. Do not rely on subcontractors for financial assistance. Don’t expect your subs to supply the managerial experience or manpower needed to complete the project. Perhaps most importantly, do not allow subcontractors to take over or perform the most vital aspects of the contract. Make sure your company performs the requisite percentage of work, as discussed below.

Will I Be Able to Fulfill the Self Performance Requirements and Comply with the Subcontracting Limitation Regulations?

The SBA regulations are very specific about the percentage of work a small business prime contractor must perform on any project to remain eligible for that project, and future small-business set-asides. The newly-revised 13 C.F.R. § 125.6 sets forth these “Limitations on Subcontracting” for contracts over $150,000.

Under the old version of the regulation, compliance with the performance of work requirements differed based on the type of small business program set-aside at issue (i.e. small as compared to 8(a), WOSB/EDWOSB, SDVOSB, or HUBZone). Moreover, the method for calculating compliance not only varied by program set-aside type, but also based on whether the acquisition was for services, supplies, general construction, or specialty trade construction.

The revised regulation is much simpler. First of all, it eliminates the differences between the different small business programs: the same rules apply to small business, 8(a), WOSB/EDWOSB, SDVOSB and HUBZone set-asides. Second, regardless of whether the contract is one for services, supplies, or construction (general or specialty), the subcontracting limitations are described in terms of “the amount paid by the government to [the prime contractor].” (That said, construction contractors will still have to exclude costs of materials from their calculations. Even so, this revision will make it much, much simpler to determine exactly how much you can subcontract and still be compliant.) Finally, as the SBA explains, the revised regulation “creates a shift from the concept of a required percentage of work to be performed by a prime contractor to the concept of limiting a percentage of the award amount to be spent on subcontractors.” For instance, rather than requiring a contractor to self-perform 15%, the revised 13 C.F.R. § 125.6 mandates that the prime contractor cannot subcontract more than 85%.

The new rule also creates a new “similarly situated entity” exception, pursuant to which “similarly situated entities” are not counted towards the applicable subcontracting limit. A “similarly situated entity” is defined as “a small business subcontractor that is a participant of the same small business program that the prime contractor is a certified participant and which qualifies the prime contractor to receive the award.” In other words, a HUBZone could subcontract to another HUBZone, or an 8(a) could subcontract to another 8(a), without counting those subcontracts towards the applicable limit. Be wary, however, if your similarly situated entity subcontractors plan on sub-subcontracting to others. Work that is not performed by the employees of the prime contractor or employees of first tier similarly situated subcontractors will count as subcontracts performed by non-similarly situated concerns.

It is critically important for small business contractors to remain cognizant of these regulations, as well as the complicated nuances of the similarly situated entity exception. Failure to comply can have a number of negative consequences, including a finding of non responsibility, a finding of affiliation, and/or other adverse impacts to your small business eligibility. If you are confused about how to calculate your self performance percentages, consult an expert with experience doing these types of calculations.

Key Considerations in Small Business Teaming: Part 1 – Teaming vs. Joint Venturing

Maria L. Panichelli is an Associate in the firm’s Federal Contracting Practice Group. Her practice includes a wide variety of federal contracting and construction matters, as well as all aspects of small business procurement.

Edward T. DeLisle is Co-Chair of the Federal Contracting Practice Group. Ed frequently advises contractors on federal contracting matters including bid protests, claims and appeals, procurement issues, small business issues and dispute resolution.