Proposed Rule Change Could Have Small Federal VARs Losing Millions, Or Even Closing Up Shop

A proposed rule change from the Small Business Administration concerning federal contracts could hit small IT VARs hard, with many of them telling CRN it could cost them millions and potentially put them out of business.

The rule change would remove an exemption under Code 541519 of the North American Industry Classification System which, according to the U.S. Census Bureau, is the standard used to classify business establishments for the purpose of collecting, analyzing and publishing statistical data related to the U.S. business economy.

As the rule stands now, federal IT VARs have two options when classifying the size of their business. They can classify their business as small if they have 150 employees or fewer or if they have no more than $27.5 million in revenue receipts. The rule change would remove the 150-employee alternative and leave VARs with the $27.5 million revenue cap as the only way to classify their business. Any VAR exceeding that revenue cutoff would no longer be considered a small business, and would lose the benefits associated with being a small business working in the federal space.

The Small Business Administration is accepting comments on the proposed rule until Nov. 10; its final decision is weeks or possibly months down the road.

Carly Goldstein, vice president of Santa Fe, New Mexico-based Wildflower International, said if the rule change goes through, Wildflower would probably have to shut down.

Wildflower is a $200 million company with 60 employees, making it a small business under the current rules. If the company loses that designation, tens of millions of dollars a year in contract revenue would be in jeopardy.

"In short, we would either have to drastically downsize or even outright close our doors," Goldstein said. "It's very personal to me. It is my life. It's the lives of everyone who works for me. We have been growing since 2007 and cutting that off and cutting off the opportunity for that growth doesn't make sense," she said.

Wildflower collaborates with many other small VARs on projects, according to Goldstein, and from conversations she has had with them they are "without question" also feeling the heat.

"We are not unique," Goldstein said. "We're all in the same boat, looking at each other and throwing up our hands and asking, 'Why? What is this even about?' " she said.

The problem with the new cutoff, according to the VARs interviewed by CRN, is that it pits any business with $27.5 million or greater in revenue directly against giants such as CDW, SAIC, Hewlett-Packard and IBM in the federal space.

"That's not fair. That would mean that you're going to have a boxing match between a 5-year-old kid and a guy that's 50. That wouldn't be a fair fight, would it?" said Lloyd Chapman, president of the American Small Business League, a small-business advocacy group that is pushing to keep the exception in place.

Next: A 'Terribly Unfair' Approach To Small VARs

Lloyd estimated that $100 billion in contract revenue a year would be taken from small businesses and given to large businesses if the exception were removed. That's a conservative guess given the data he has seen, he said. According to American Small Business League research, approximately 18,000 companies would be directly affected by the rule change.

"What they're trying to do with this issue is change that size standard to a level where legitimate small businesses can't compete," Chapman said. "It will wipe out an entire industry," he said.

Augie Riolo, president of Virginia Beach, Va.-based Knowledge Information Systems, said that his business has 27 employees and between $30 million and $35 million in annual revenue. At that size, it would qualify it as a large business if the rule change goes through. If that did happen, he said Knowledge Information Systems would struggle to compete directly against the big players in the federal space with higher volumes and better price points.

"We don't have a chance in hell against that group," Riolo said.

A 'TERRIBLY UNFAIR' APPROACH TO SMALL VARS

Jim Fontana, partner at Dempsey Fontana, a Reston, Va.-based law firm that specializes in federal contract law for VARs, said that small VARs have outgrown the standard revenue threshold and, without the employee-size standard exception, they would go out of business. While he wouldn't say how many of his clients would be affected, he estimated that there were hundreds or thousands of small VARs that would be hit hard, including some having to institute layoffs and some actually shutting their doors.

"Many of these small VARs are going to be put out of business," Fontana said. "That's the long and short of it. It's a terribly unfair and ill-advised approach to these small VARs."

Steve Halligan, president and COO of Washington, D.C.-based n2grate, said he doesn't expect any change to affect his business drastically as it bids mostly on full and open contracts, but he said he anticipates it will have a drastic effect on the majority of small VARs that do rely on small-business-specific contracts. In particular, he said that he expects it will stifle opportunities for growth for small IT VARs.

"I think it will stifle or create an inability for a company to break through and become a thriving, growing, hiring business. It will just add additional hurdles for companies to break through and be great companies supporting the federal government," Halligan said.

An executive from an East Coast-based federal VAR, who did not wish to be identified, said that his 700-employee business is still feeling the effects of undergoing the transition from a small to large business in the federal space. While the rule change would not affect his company at its current size, the executive said that the transition process from small to large in the eyes of the federal government is extremely difficult, and one in which the "door kind of shuts." The executive said that while his company has managed to win some contracts over large federal contractors such as Lockheed Martin, those cases are very rare.

"Making that transition is quite difficult when you have to compete with the larger companies," the executive said.

Next: Small Business Administrator's Reasoning

SMALL BUSINESS ADMINISTRATION'S REASONING

The reasoning behind removing the exception is to simplify the federal contracting process as much as possible and build consistency, said Ken Dodds, associate administrator for the Office of Policy and Planning at the Small Business Administration, in an interview with CRN.

"Government contracting is so complex," Dodds said. "I think any time you can simplify it, that helps the general public."

The proposed changes are based on economic census data from 2007, said Khem Sharma, size standards division chief at the Small Business Administration. Sharma said that the data suggests that most companies, up to 99 percent, would still qualify under the $27.5 million revenue cap.

"We have more recent data, but that's the only data that's currently available," said Sharma when CRN brought up the fact that the industry has changed drastically since 2007. The 2012 census data will be available some time next year, Sharma said, adding that the agency will re-evaluate the codes at that time based on the new data.

However, even before new data is taken into account, the two representatives from the Small Business Administration said that they didn't think it would materially affect any small VARs. They said they felt there was confusion around the size standard and what rules apply to each small business.

"I don't think anyone is going to lose their status of small business," Dodds said.

"Even if they lose, the number will be very, very small," Sharma added.

However, Chapman from the American Small Business League said that the data doesn't add up. He said that the data provided by the Small Business Administration provides for $140,000 in revenue per employee, an amount he called "laughable," saying you "couldn't pay your light bill with that." With profit margins around 5 percent for the average federal VAR, Chapman said his data shows the average IT VAR in the federal space does closer to $1.5 million a year per employee.

Knowledge Information Systems' Riolo agreed. While there are many other types of businesses where $27.5 million in revenue would be a good small-business cap, he said that just isn't true for an IT VAR.

"It's just not in the ballpark of what the high-volume, low-margin IT VAR is," Riolo said.

"While [the Small Business Administration] thinks they're doing the right thing and thinks they're helping, the fact of the matter is that people in this category are going to get hurt by this," Riolo added.

In the meantime, Wildflower's Goldstein said that the company will continue to hire more employees and ramp up its efforts to provide the same standards of support to its federal clients. It will continue to do that until it hears differently, but Goldstein said that she hopes the company doesn't have to change course and stunt the growth it has seen over the past several years.

"This isn't happening yet. You have to perform to the standard our customers are used to. They hired us based on our reputation, on our amazing past performance," Goldstein said. "We have to do that even in the face of this until someone tells us differently."

PUBLISHED NOV. 3, 2014