Landscape or “Minescape” for Potential Mergers with Government Contractors
As we work with potential acquirers of government contractors, it sometimes feels like we are holding hands and walking through a minefield. Last year’s government budget landscape was full of potential mines just waiting for us to make a wrong step and boom! Sequestration cuts, occasional insourcing of positions, government shutdown, procurements shifting to Lowest Priced Technically Acceptable solicitations, and other potential “landmines” all collided to make buyers very wary about investing their capital in the government contractor market.
The mergers and acquisitions (M&A) market for government contractors has changed dramatically in the past two years, and appears to be warming up a bit from last year’s deep freeze. We offer some observations based on our work with both buyers and sellers.
- Buyers are still looking to add capabilities, expanded qualifications and contracts that will provide entry into new markets and customers. The best matchups of buyer and seller often occur when a buyer realizes that a potential acquisition will do more than just expand their presence with the same set of customers.
- That does not mean that buyers will blindly accept a seller’s backlog report as guaranteed. Buyers are scrubbing backlog reports thoroughly and making sellers “prove” that individual contract backlog is real. With contract funding histories often looking erratic, this can prove to be a challenge for buyers to get comfortable with the certainty of continued funding and exercise of option periods.
- If a seller has contracts in their backlog that were awarded based on a preference program such as small business, 8(a), Service-Disabled Veteran-Owned Small Business (SDVOSB), Woman-Owned Business (WOB) or other program, then buyer and seller are wise to discuss their strategy for handling these contracts at closing. Many buyers are quite willing to accept the risk of losing certain small business contracts upon re-certification as a large business if they can meet the customers and understand the contractor’s relationship with the customer. Often, the issues associated with contracts won under a preference program are like the elephant in the room that nobody wants to discuss. Better to put these issues on the table early before a lot of time is wasted on fruitless negotiations.
- Sellers need to do a little soul searching prior to beginning a sale process to estimate how much their business may be worth, and how much each owner is looking to take home at closing in cash, promissory notes, earn-outs or stock of the buyer. Knowledgeable investment bankers and valuation firms can help provide a ball park estimate of business value. In many cases, expectations can also be set about realistic cash expectations. Sellers should spend a little time with their tax advisor to estimate how much in taxes will need to be paid at closing. Sellers often pull out a cocktail napkin and calculate their tax bill equal to the 20 percent federal capital gains tax rate. They often forget that almost all states also charge state income tax on capital gains. And the new Net Investment Income Tax (a.k.a. “Medicare surtax”) may add another 3.8 percent to all capital gains for taxpayers with adjusted gross income of $250,000 or more. Additionally, don’t forget that companies who have historically paid taxes on a cash basis will also have to pay taxes on all assets (usually the biggest of which are accounts receivable) which have been previously untaxed. Adding all of these items together, and it’s not unusual for the seller’s total tax bill to equal 40–50 percent of the sales price after paying off bank debt. We have heard more than one seller start questioning whether the net cash at closing is worth it!
- In this era of shrinking defense budgets, everyone who sells to the government has realized that revenue growth is hard to achieve. Many small businesses are looking at mergers with other small businesses, especially when the combined company can still certify as small business under key North American Industry Classification System codes. Expanded capabilities, and the ability to leverage general and administrative expenses, often provide attractive reasons for two small businesses to tie their ships together.
Selling to “the world’s largest customer” has more than its share of challenges in a difficult budget environment. However, this can also be a good opportunity to expand through acquisition when the right opportunity can be found.