The Small Business Administration (SBA) published earlier this month one of the most significant rule changes in recent history. We previously addressed the new M&A and long-term recertification rules. Now, we’ll examine the homogenization of the negative control rules across the SBA’s small business and socioeconomic programs, as well as the approval of rights of first refusal (ROFRs) for all these programs.
These rule changes could materially improve access to capital for 8(a) program participants, woman-owned small businesses (WOSBs) and service-disabled veteran-owned small businesses (SDVOSBs). These socioeconomic firms have historically struggled to attract investors because the SBA rules do not grant minority owners meaningful control over the actions of the company, in particular “negative controls” — that is, not the right to affirmatively control the actions of the company, but the right of a minority owner to block the majority owner from taking certain actions on behalf of the company.
The SDVOSB rules previously permitted only five such negative controls. Minority owners could stop the SDV owner from (1) adding a new equity stakeholder or increasing the investment amount of an equity stakeholder[1]; (2) dissolving the company; (3) selling the company or all assets of the company; (4) merging the company; and (5) declaring bankruptcy on behalf of the company. These controls are not particularly needle-moving on their own; in the commercial world, sophisticated investors would expect more than just these five blocking rights. And the 8(a) and WOSB programs prohibit all negative controls, which substantially limits their pool of investors even more. The result is that most SDVOSB, WOSB and 8(a) companies have to fund their growth with bank loans and their own net income. Investment funding is often not a viable option in light of the expectations that sophisticated investors have regarding control.
The new rules should alter this paradigm. By expanding the list of permissible negative controls and permitting ROFRs for all socioeconomic firms, the new rules pave the way for sophisticated individual and institutional investors to take minority equity interests in such firms — which should provide these firms with alternative options for facilitating and accelerating their growth.
Expanded Negative Controls for SBA Small Business Programs
The new rules adopt the negative controls from the SDVOSB program but add a sixth control, amending the company’s governance documents to remove the shareholder’s authority to block any of the negative controls. Further, and most crucially, SBA has added a “catch all” control permission that permits negative control over “any extraordinary action that is crafted solely to protect the investment of the minority shareholders, and not to impede the majority’s ability to control the concern’s operations or to conduct the concern’s business as it chooses.”
This is not a new category of controls for SBA — for years, the SBA’s Office of Hearings and Appeals (OHA), in performing an affiliation analysis, has distinguished between “extraordinary” and “ordinary” corporate actions. See, e.g., Size Appeal of S. Contracting Sols. III, LLC, SBA No. SIZ-5956 (2018) (citing Size Appeal of Carntribe-Clement 8AJV #1, LLC, SBA No. SIZ-5357 (2012). According to these cases, if a minority equity owner can block only the “extraordinary” actions of the company, the minority owner is not “affiliated” with the company. But if the minority equity owner can block “ordinary” actions of the company, this causes affiliation between that owner and the company. “Extraordinary” actions were roughly defined as those affecting investors and their equity interests; “ordinary” actions typically involve the management and administration of the concern itself.
In a significant and unprecedented move, SBA now is applying this case law concept to all socioeconomic programs, meaning that minority equity owners of 8(a), WOSB and SDVOSB concerns can now block case-law-designated “extraordinary” actions, including but not limited to:
- Entering into a substantially different line of business
- Initiating or settling litigation
- Mortgaging or encumbering all or substantially all assets of the company
- Changing the amount or character of the company's contributions to capital
- Disposing of the goodwill of the company
The new rules also do not stop at only those “extraordinary” controls previously approved by OHA; they operate as a catch-all for “action that is crafted solely to protect the investment of the minority shareholders, and not to impede the majority's ability to control the concern's operations or to conduct the concern's business as it chooses.” So, even if a certain control has not been previously approved by OHA, the rule leaves room for a company to argue that it should be permitted.
This opportunity for advocacy is useful because socioeconomic program participation requires certification at SBA. Investors and small businesses will be able to gain clarity up front regarding whether their proposed controls are permitted by SBA program rules. This is not how the “extraordinary vs. ordinary” divide has worked historically because this case law would be enforced only in the context of affiliation challenges during size protests.
In other words, while contractors could structure their governance rights with the intent to comply with SBA’s control rules, unless there was an affiliation challenge via a size protest or a requested size determination, they were left to guess whether their structure did in fact comply. This need for guesswork often led to contractors jettisoning terms that were not previously approved explicitly, out of fear of potential noncompliance, even if the parties were reasonably confident SBA would be OK with the term. And this sense of uncertainty worked to stymie investment further — firms relying on their socioeconomic or size status to win work and grow need to be certain that such status will not be revoked.
But now, companies seeking to certify as 8(a), WOSB or SDVOSB (or previously certified firms intending to expand their corporate control rights as permitted by the new regulations), will be required to gain SBA approval of the same. So, rather than wait for a size or status protest that asks the question, socioeconomic firms will learn almost immediately whether SBA approves or rejects their proposed controls. This should expedite elucidation of the line between extraordinary and ordinary controls and lessen the need for the above-referenced guesswork.
The Adoption of ROFR Rules for Small Businesses
In a related change, the SBA has also permitted Rights of First Refusal (ROFRs) for all small businesses, including socioeconomic firms, where the ROFR follows "normal commercial practices.” A ROFR grants a minority owner the contractual right to step in front of a third-party buyer seeking to purchase the majority owner’s equity interest. Most often, the ROFR says that when a third-party makes a bona fide offer to buy out a majority owner, the minority owner has a certain number of days to elect to purchase the majority’s interest at the same price and on the same terms as offered by the third-party. Historically, these rights have been deemed to infringe on the SBA requirement that socioeconomic owners have “unconditional” ownership of their firms. Being unable to choose the precise identity of the buyer was an unacceptable “condition,” according to OHA case law.
However, ROFRs are common in the commercial marketplace. Without them, investors fear that they’ll be stuck in a partnership with a stranger, or worse, a competitor. As a result, the prohibition of ROFRs was a significant impediment to small business investment. This change is therefore thematically consistent with SBA’s negative control expansion, all seemingly aimed at facilitating capital access for socioeconomic firms.
Conclusion
Predicting investment trends with any degree of confidence is unwise. Markets are multifactorial. Simply amending regulations with the intent to facilitate investment does not guarantee that outcome. Moreover, the changes discussed above do not fully embrace commercial practices. The National Venture Capital Association, for example, prescribes form documents for minority investors that come with significantly more negative controls than those legalized by this rulemaking. Therefore, it would be a mistake to assume that, suddenly, socioeconomic firm investment activity will mirror that of commercial small businesses.
However, these new rules are certainly a step in that direction. Whether the impact is large or small, socioeconomic firm investment should increase because of these new rules, which should improve capital access, which should, in turn, facilitate greater performance capacity.
Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. The author has provided the links referenced above for information purposes only and by doing so, does not adopt or incorporate the contents. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.
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