Mo Money, Mo Problems

One of the weird risks of running a small government contracting business is that your company can get too big.

Suppose you run a company that does work under NAICS code 541512, which means you provide Computer Systems Design Services. Suppose also that you want to stay a small business for federal-contracting purposes because you want to compete for small-business set-asides. To accomplish that, you will need to make sure your average annual revenue is under $34 million over the course of 5 years. If, however, you suddenly receive $175 million in contracts over the course of a year, at least two things are true: (1) you absolutely should tip your blogger; and (2) you are no longer running a small business.[1]

In the parlance of govcon, you have "graduated" to an "other than small" business status. And now, you are no longer competing against other small businesses for small-business set-asides. You are competing with the entire population of businesses, big and small. Folks have been complaining about this two-tier structure for a while, but there is no "middle tier." You're either small, or you're not small.

But close readers of this newsletter know there is another option. Yes, that's right: NAICS arbitrage.

Often, when discussing NAICS arbitrage, I describe it in the context of higher revenue limits. Like, if you have a $34 million revenue limit, maybe you can find one with a $45 million limit.

Not all NAICS codes are based on revenue, though. Some NAICS codes are based on the number of employees at the company. In some situations, then, the real arbitrage opportunity is switching from a revenue-based NAICS code to an employee-based NAICS code. And one particularly notable example of this is the rule for "Information Technology Value Added Resellers" (ITVARs) under NAICS code 541519.

Typically, companies under the NAICS code 541519 have a revenue limit of $34 million, just like those companies under 541512. But there's an exception for NAICS code 541519 specifically for ITVARs, which sets the size standard at 150 employees.[2]

So, if you are an ITVAR and you can deliver a large enough portion of total contract value to satisfy the requirements with a minimal number of humans, you can grow to infinite revenue and stay a small business as long as you are under 150 employees. (There's a catch, which we'll talk about next week, but stay with me for now.) It's a great arb opportunity! Or, at least it has been so far.

Which brings us to the draft solicitation for the next-generation NASA Solutions for Enterprise-Wide Procurement (SEWP) VI contract scheduled to hit the streets out some time this quarter.[3] As we've discussed before, SEWP V (the predecessor to SEWP VI) is a very large government-wide IT acquisition vehicle. How large? SEWP V processed over $12 billion in volume last fiscal year, and the volume continues to grow year over year.

Critically (notably! incredibly!), out of that $12+ billion, almost $9.7 billion of that has gone to the 106 small businesses currently on SEWP V. That's a lot of revenue for a small business. If you do the math, that means—on average—those small businesses received $91.5 million in revenue each year.

How could they receive $91.5 million annually and stay small? Yes, right, exactly: NAICS arbitrage! Because NASA SEWP V used the ITVAR rule for NAICS code 541519, those companies can have annual revenues at 3x the revenue limit for normie 541519 companies.

It's a great deal for those companies that are on SEWP. Huge revenue potential. Small labor costs. All that jazz. As long as they stay small, that is...

Now, though, there are some changes afoot. As part of the NASA SEWP VI contract, NASA is now considering using NAICS code 541512, not NAICS code 541519. And NAICS code 541512—as you'll recall—is revenue-based.

This has created, um, some bruxism[4] among the govcon community, recently manifesting in a letter from the Chairman of the House of Representatives Committee on Small Business to the NASA Administrator. That letter, which requests a staff-level briefing, minces no words about the committee chair's concern:

The Committee is concerned that the revenue-based size standard proposed for use in SEWP VI limits small business’ ability to service task orders without compromising their size status.

"Compromising their size status" is an excellent framing of the risk. And whatever you may think about the committee's position here, we can all agree that having NAICS arbitrage suddenly top of mind for the committee is a win.

You can understand why NASA SEWP incumbents (challengers, too!) and their elected representatives would be worried about a potential shift away from an employee-based limit. In fact, folks have been pretty transparent about the fear. Here's a recent beltway article on the topic, quoting a govcon consulting CEO and a govcon lawyer:

Stephanie Geiger, the CEO and founder of the Geiger Consulting Group, a federal marketing and communications expert, said if NASA continues to use the current small business size standard, it would be a major blow to small firms.

“Based on the revenue size standard currently included in the draft RFP, many small businesses have already met and surpassed that size standard making it difficult for small businesses to pursue SEWP VI without JVs or mentor/protege agreements unless they want to shift categories,” Geiger said. “We predict there will be no small businesses left within three years of contract award.”

Eric Crusius, a partner with Holland and Knight, said the changes NASA is suggesting would have far reaching consequences on the vendor community for many years.

“Small businesses with few employees will now be competing with the largest contractors in the world for those contracts,” he said. “The change in the NAICS Code may result in lower performance metrics because the companies that will qualify as small businesses will be much smaller and may not have the experience of providing large scale product orders to the government. It may also cause more turnover because smaller companies handling these orders will more quickly size themselves out of the small business thresholds.”

Yes, there is the risk: a small business can grow too much! That's it. That's the worry.[5]

Still, the letter gives some hint as to the reason why NASA is considering moving away from the employee-based 541519 code and toward the revenue-based 541512 code. Next week, I'll dig a bit into what might be going on.

But in the meantime, the very weird lesson here is that government contractors — even extremely successful ones — need to take seriously the risk of growing too big to compete.

Or, as Kelly Price's immortal hook explained it: "It's like the more money we come across, the more problems we see."

[1] And, like, maybe quit while you're ahead? As a thought experiment, I feel like if I ran a business that went from $0 to $175 million in a year, I'd sell it and retire. Prove me wrong? I guess if someone wants to pay me $175 million this year, I would be happy to run this experiment for real.

[2] Here's the full text of the exception for those who care about such things:

An Information Technology Value Added Reseller (ITVAR) provides a total solution to information technology acquisitions by providing multi-vendor hardware and software along with significant value added services. Significant value added services consist of, but are not limited to, configuration consulting and design, systems integration, installation of multi-vendor computer equipment, customization of hardware or software, training, product technical support, maintenance, and end user support. For purposes of Government procurement, an information technology procurement classified under this exception and 150- employee size standard must consist of at least 15% and not more than 50% of value added services, as measured by the total contract price. In addition, the offeror must comply with the manufacturing performance requirements, or comply with the non-manufacturer rule by supplying the products of small business concerns, unless SBA has issued a class or contract specific waiver of the non-manufacturer rule.

[3] Why is it SEWP VI? Here's a great blog post with a history of the 5 generations of SEWP, including screenshots of the prior SEWP websites. I honestly love them!

[4] Yes, Jason Miller of Federal News Network calls it "wringing [of] collective hands." But I prefer "gnashing of teeth." Industry isn't sitting around worrying; they're out there exercising their First Amendment rights and lobbying. Oh, knock it off; stop clutching your pearls.

[5] I dunno. I feel like some govcon executive somewhere should write the Beltway version of Peter Thiel's "Zero to One," and call it "Zero to 149." But, instead of adopting Thiel's post-Hobbesian vision of driving companies toward monopolistic profits, Zero to 149 would be about how, given enough time, Rousseau would have invented the FAR.

Subscribe to GovContrActually

Don’t miss out on the latest issues. Sign up now to get access to the library of members-only issues.