Far too often, investors, including venture capital companies, assume that as long as they do not retain the largest shareholder interest in a company, that they cannot create affiliation problems impacting what is a key to companies’ initial success in government contracting: small business status. Wrong. A recent U.S. Small Business Administration (SBA) Office of Hearings and Appeals (OHA) decision makes this a stark reality, upholding a determination that an apparent awardee in a set-aside procurement is other-than-small based on affiliation arising from its mere 4.16 percent stock ownership interest in another company.

Affiliation Generally
If a contractor has ever thought about certifying its size as small under a particular NAICS code, hopefully they reviewed the SBA regulations on affiliation in advance. The analysis of whether a company is small in size does not start and end with the receipts or number of employees for that company, but is instead considered as a spiderweb of connections with other individuals and entities. In order to determine a concern’s size, SBA counts not only the receipts or employees of the concern but also the receipts or employees of each of the concern’s domestic and foreign affiliates.

Concerns and entities are affiliates of each other when one controls or even has the power to control the other, or a third party or parties controls or has the power to control both. 13 C.F.R. § 121.103(a). In determining affiliation, there are numerous factors that the SBA must consider – including, ownership, management, and previous relationships with or ties to other concerns. SBA’s analysis concerns the totality of the circumstances; the absence of any single factor will not be considered dispositive.

Affiliation Based on Stock Ownership
For a concern that has issued stock or owns stock in other entities, a size determination should take into consideration affiliation based on stock ownership. The SBA regulations contain three different tests to determine affiliation (at 13 C.F.R. § 121.103(c)):

If	Then	Under SBA Regulations
A person owns/controls at least 50% of a concern’s voting stock or a block of voting stock which is large when compared to other blocks	→	That person is presumed to control or have the power to control the concern. (This presumption is not rebuttable)
Two or more persons own/control less than 50% of a concern’s voting stock and these minority holdings are equal or approximately equal in size and the aggregate of these minority holdings is large as compared with any other stock holding	→	Each such person is presumed to control or have the power to control the concern whose size is at issue. (This presumption is rebuttable)
A concern’s voting stock is widely held and no single block of stock is large as compared to all of the others	→	The concern’s Board of Directors and CEO or President are deemed to have the power to control the concern in the absence of evidence to the contrary.

Although absolutely crucial concepts, the SBA regulations on their face provide no further definition of when a block of voting stock is “large compared to other outstanding blocks of voting stock,” when blocks of stock are “approximately equal in size,” or what it means to be “widely held.” Instead, contractors have to look to scores of fact-specific SBA OHA decisions to understand these terms. For example, in a seminal case on what it means for a block of voting stock to be large when compared to other blocks (the first test discussed in the above chart), OHA determined that a 49 percent block of stock is large in comparison to a 36 percent block (causing affiliation), whereas a 49 percent block of stock is not large in comparison to a 41 percent block (not causing affiliation). The H.L. Turner Grp., SIZ-4896 (2008); Novalar Pharmaceuticals, Inc., SIZ-4977 (2008) (discussing H.L. Turner). Having to parse through the nuances of OHA’s decisions on stock ownership percentages to see where a concern’s stock distribution falls within the case law can leave a contractor with a lot of uncertainty, particularly in cases on the margins. But, a recent decision out of OHA demonstrates that even when stock ownership falls squarely within the plain meaning of these tests – in this case, where there were equal blocks of stock – contractors can still get tripped up.

OHA’s Finding of Affiliation Based on a Mere 4.16 percent Stock Ownership Interest
In Government Contracting Resources, Inc., SIZ-5706 (2016), OHA upheld an Area Office size determination concluding that the concern at issue exceeded the NAICS size standard due to affiliation arising from its 4.16 percent ownership in another company, Valley Indemnity, Ltd. (Valley), under the minority shareholder test. The contractor at issue, Government Contracting Resources, Inc. (GCR), was the apparent awardee in a service-disabled veteran-owned small business (SDVOSB) set-aside procurement. Two unsuccessful offerors promptly filed size protests. The Area Office determined that GRC was not small, a determination that was appealed to OHA. Although OHA remanded once to the Area Office for further development, the second time around, OHA upheld the finding that GRC was other-than-small.

At issue was GRC’s investment in Valley. Approximately twenty companies, including GRC, each owned an equal minority interest in Valley (of 4.16 percent). Under the applicable stock ownership test (the second test discussed in the above chart), each minority owner – including GRC – controls or has the power to control Valley. GRC does not appear to have appealed the application of that specific stock ownership test.

Rather, the fight turned to whether GRC had rebutted the presumption that it controlled Valley based on its 4.16 percent ownership interest. The President, CEO, and majority owner of GRC also served on Valley’s Board of Directors. Among other arguments, GRC asserted that because it only has a 4.16 percent ownership interest and that its President/CEO/majority owner is just one of 26 board members, GRC’s interest in Valley is not large enough to “create a quorum, prevent a quorum, cause any vote to pass, block any vote nor cast a tie-breaking vote.” But, as OHA pointed out, if it were to accept this argument, then none of the owners who have an approximately equal share in Valley would control, with the result that no one controls Valley. And, under OHA’s precedent, a concern must be controlled by at least one person or entity. Accordingly, GRC failed to rebut the presumption of control, and OHA upheld the Area Office’s finding of affiliation between GRC and Valley and the determination that GRC exceeds the applicable size standard based on the combined receipts of it and its affiliates, including Valley.

Takeaways Regarding the Minority Shareholder Test for the Prudent Investor
First, the affiliation analysis is not limited to who owns or manages the particular concern whose size status is at issue – rather the analysis also extends to which entities that concern manages, controls or has the power to control.

Second, be mindful about entering into scenarios in which the largest shareholders have equal minority interests (and the aggregate of these minority holdings is large as compared with any other stock holding) because it expands the number of individuals/entities who control and can create affiliation problems.

Third, if your largest shareholders must have an equal minority share in a company or entities have equal minority shares in your company, the key to rebutting the presumption of control under the “minority shareholder rule” is that a concern must show that someone else (preferably someone who does not create affiliation problems) actually controls the entity through corporate decision making (i.e., the Chairman of the Board). OHA has repeatedly refused to accept the argument that a concern with multiple owners is not controlled by any person or entity. The “minority shareholder rule” was created precisely for circumstances where no single person has actual affirmative or negative power to control a concern – so an argument that an interest is simply not large enough to control is going to be insufficient to rebut the presumption.