The government has (size) standards

Close your eyes, imagine you're not the sort of person who reads newsletters about government contracts, and ask yourself "how big can a business be before it's no longer considered a small business?"

It turns out that this is a really complicated question in government! Supposedly, "the Internal Revenue Code contains at least 24 different definitions of a small business".[1] Even the same law can have multiple answers![2]

For purposes of federal contracting, though, the answer is determined by the US Small Business Administration's Office of Size Standards,[3] which publishes a Table of Size Standards. The way it works is that SBA uses the Census Bureau's North American Industry Classification System (NAICS) to categorize businesses into different industries, and then establishes whether individual firms are small based on average annual gross receipts or the number of employees.[4]

NAICS codes are all over the place, with classifications like Credit Unions (522130), Drive-In Motion Picture Theaters (512132), Motor Vehicle Towing (488410), and Offices of Lawyers (541110). There are so many NAICS codes because there are so many different types of businesses in North America!

And the SBA's approach of organizing businesses by category and then looking at revenue and employee numbers has a kind of intuitive appeal to it. My local restaurant may employ more people than the local bank, but the bank is going to have significantly more assets and receipts than restaurant. Accountants and lawyers may both work in professional-service firms, but the differences between small and big accounting firms and small and big law firms are pretty vast. So, being more granular with a NAICS code and then figuring out whether revenue or employees seems pretty rational.

But there are two kind of weird problems. First, to the uninitiated, the size standards are pretty large! Companies can have millions of dollars in revenue and hundreds of employees and be considered small. Considering that 95% of all businesses in the US have fewer than 50 employees, these size standards can seem disorienting.

The other, bigger problem? NAICS arbitrage.

Here's one way this might work (though, ahem, this is definitely not legal advice):

  1. Suppose you have long operated a family Christmas Tree Farm (classified as Nursery and Tree Production, NAICS 111421). On average, you have $3 million in annual gross receipts. Because the size standard for that NAICS code is $3.25 million, you're operating a small business!
  2. Since the pandemic, business has really picked up! Now you're averaging $3.5 million in gross receipts over the past five years. Business is good you might think! But now you've got a problem: you're not a small business anymore!
  3. Thinking ahead, though, you decided to stop growing your own trees and, instead, started selling Christmas Trees that other people have grown on their farms. Now, you classify yourself as a Nursery, Garden Center, and Farm Supply Retailer (NAICS 444240). That NAICS code has a size standard of $21.5 million. Congrats: you're back to operating a small business with a lot of cushion for growth!

It's kind of amazing if you think about it. You're selling the same thing (Christmas Trees), but by opting to reclassify what sort of business you're in, you can choose a NAICS code where you'd still be classified as a small business. This is not a loophole, exactly. It's how it's supposed to work?[5] But a quick review of the Table of Size Standards has all kinds of these arbitrage opportunities.

And one place where NAICS arbitrage becomes really important is when it comes to small business set-asides for government contracts.

Here's how this can go:

  1. Contracting officers are, in many cases, required or incentivized to "set aside" acquisitions for small businesses, which means that only a small business can compete to be the prime contractor for that acquisition.[6]
  2. Depending on what the requirements are, a contracting officer chooses which NAICS code applies to that particular acquisition.
  3. Depending on what NAICS code applies, some companies may be excluded from competition.
  4. Capture managers and, occasionally, lawyers get involved arguing that the contracting officer should use a different NAICS code.

Normally, this happens outside of the public view. But sometimes it ends up with litigation culminating at the SBA's Office of Hearings and Appeals.

Here was a fascinating case from a few weeks ago, where the issue boiled down to whether the U.S. Department of Defense, Defense Health Agency (DHA) was trying to acquire "General Medical and Surgical Hospitals" (NAICS 622110) or whether it was trying to acquire "Offices of Physicians (except Mental Health Specialists)" (NAICS 621111) when it put out an RFP for "professional medical (i.e., clinical) and medical support services to either supplement existing medical staffs or provide full operational services on-site or off-site in support of mission requirements within federal hospitals, clinics, and dental facilities."

In other words, did DHA really need a hospital? Or did DHA just need the doctors?

The difference mattered quite a lot! For NAICS 622110, the size standard was $47 million. For NAICS 621111, the size standard was $16 million. That's nearly 3x the average annual gross receipts!

That the NAICS code chosen would allow much larger companies to bid was not a surprise to the contracting officer. Indeed, it was part of the strategy. Among a handful of other arguments, the contracting officer (CO) explained that the larger of the two NAICS codes should apply because it would benefit more small businesses:

[T]he CO selected NAICS code 622110 because this code is "most likely to be successful in obtaining these services from small businesses", as DHA already has 30 small businesses that are currently performing work under NAICS code 622110 for the predecessor MQS contracts. If DHA were to select a different NAICS code, this could potentially limit the ability of incumbent small businesses to compete for the RFP.

On appeal, the SBA disagreed with the contracting officer about which NAICS code should apply. The bottom line was DHA was not "seek[ing] contractors that are, themselves, licensed hospitals.... Instead, the principal purpose of this RFP is to acquire medical staffing services." So, $16 million size standard it is.

As a result, some of the incumbents may be excluded from competing on the procurement.

And yet, were those incumbents small businesses that were excluded from competition? I guess the answer to that depends on where you sit on any given NAICS arbitrage.

By the way, the NAICS code for Independent Artists, Writers, and Performers (711510) has a size standard of $9 million. I am pretty sure I would not be offended if GovContrActually were to exceed that size standard. Prove me wrong, please?

[1] In 2022, the Congressional Research Service cited another CRS report citing a 2003 academic paper for this claim. I certainly have no intention of going beyond CRS here, but a lot can change in 20 years? Anyway, my guess is that there are probably more definitions today than there were in 2003.

[2] See, e.g., Obamacare.

[3] I love that this office exists!

[4] I went down an incredible rabbit hole reading about the methodology that the Office of Size Standards uses to establish the Table and, well, it's kind of amazing. Also, the legislative / regulatory history here is equally amazing.

[5] Also, it presumably took some effort. You had to start sourcing Christmas Trees from other farms, ensure quality, manage inventories with greater up-front capital expenditures, etc.

[6] It doesn't mean that large businesses can't be part of the action. But that's for another day.

Subscribe to GovContrActually

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