BLOG: Corporate Transactions and Affiliation Pitfalls

May 28, 2019

By Francis G. Massaro
Practice Area: Business & Corporate Law

As a small business grows and expands, it may have opportunities to bring on new investors, provide equity incentives to obtain, incentivize and retain key employees and directors, and enter into acquisitions and other transactions with other entities.

These investments and transactions can support the business’s stability and future growth but may also raise unintended affiliation issues.

Because the Small Business Administration (SBA) includes the business’s affiliates when determining its size, pursuing these transactions may affiliate the business with other entities, possibly jeopardizing its eligibility under SBA programs and its ability to obtain contracts set aside for small businesses.

As a result, to minimize the risks associated with affiliation, a small business should understand how corporate transactions may affiliate it with other entities.

Stock Options and Convertible Securities

Stock options are useful tools to obtain, incentivize and retain key employees. They permit the employee to purchase shares of stock at a set price, allowing the employee to benefit from the increase in the underlying value of the option shares during his or her employment.

Convertible securities likewise are useful tools to attract investment in the business, while providing the owner of the security the opportunity to participate in the upside of ownership with less downside.

While stock options and convertible securities do not represent ownership in the business until the holder exercises them, they (and any similar “rights to acquire equity”) are considered “exercised” for the purposes of determining size.

The result is that the holder is deemed to own the shares in determining ownership and control of the business.

Depending on the number of shares represented by the options or convertible securities and the number of shares that the holder already owns, stock options or convertible securities can affiliate the business with an investing entity, even though that entity does not yet own the shares or currently exercise control over the business.

While stock options and convertible securities may affiliate the business with other entities that the holder controls, they will not divest control from an individual or entity that controls the business until the holder exercises the options or convertible securities.

Common Management

Entities may bring on new investors or owners as they grow or require additional capital. These agreements may permit the investor to name one or more directors to represent their interests in managing the business.

If the investor has the ability to appoint a majority of the directors, or if the directors that the investor appoints have the power to veto certain transactions, the investor will be found to control the business.

If the investor has similar arrangements with other entities, the business risks affiliation with other entities that the investor controls.

Agreements to Merge

The owners of a business may decide to acquire, or sell the business to, another entity through a stock purchase, merger, or other transaction.

Following the consummation of the transaction, the businesses will be affiliated because one will control the other.

However, agreements to merge can affiliate the businesses before the transaction is fully consummated. In fact, businesses are found to be affiliated when they have an “agreement in principle” to merge, which may be established while negotiations remain ongoing, often upon signing a letter of intent, and before the transaction closes.

The entity should understand how the transaction will affiliate it with other entities, including those affiliated with the other party to the transaction, and how the timing of the transaction may affect its size certification for proposals submitted prior to closing.

Joint Ventures

Rather than seeking new investors or an acquisition, a small business may pursue a joint venture with other entities.

A joint venture is an association of entities that pursues a limited number of specific or limited-purpose business ventures by combining their efforts, money, and skills. A joint venture can allow the small business to collaborate with other entities to obtain government contracts that it may be unable to obtain and perform with its expertise alone.

Joint ventures can open new avenues to obtain government contracts without the affiliation risks associated with equity investments. However, if the joint venture is awarded more than three contracts in a two-year period, the participants will be considered affiliates.

In addition, the small business’s share of the joint ventures receipts and employees will be included in the calculation of its size, so the business should determine how the joint venture will affect its size status.

You may contact a member of PilieroMazza’s Business & Corporate Law practice group if you have questions concerning this blog. This post is the work of Francis G. Massaro, an associate with PilieroMazza PLLC.

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