Focused due diligence and a carefully negotiated agreement can help mitigate risks for government contractors engaged in a merger or acquisition. The U.S. government contracting market has continued to see significant M&A activity from both private equity and strategic buyers. This is due to the perceived stability, steady growth, and free cash flows being generated within the industry. In times of global insecurity, be it economic or geopolitical, government contractors often benefit from increased federal spending. Given the current conflicts in Ukraine and the Middle East and the increasing near-peer threat posed by a rapidly maturing military in China, companies that count the Department of Defense and intelligence agencies among their customers have seen their opportunities increase, while concerns of reductions in consumer spending keeps commercial companies on edge. In general, merger and acquisition targets require thorough due diligence to assess the proposed purchase price and to ensure appropriate contractual coverage for risk items. However, due to the highly regulated nature of the industry, government contractors face unique risks that can be far greater than those faced by commercial enterprises in the normal course of business. Specifically, government contractors are affected by:
* The use of significant judgment and estimates related to long-term contracts;
* Complex cost accounting and pricing regulations, under which the government has unilateral rights not found in commercial relationships; and
* Frequent audit scrutiny and significant fines and penalties, sometimes for violations involving immaterial amounts.
A small government contracting division, even a single government contract, can pose a significant risk to a company. This article will address financial risks unique to government contractors, as well as ways those risks can be mitigated in conjunction with negotiations of a definitive agreement.
Revenue Recognition
Government contractors may enter numerous types of contract arrangements with their federal customers, including firm-fixed price, cost-type/cost-reimbursable, time & material (T&M), undefinitized/letter contracts, and any combination of performance based profit structures, such as award fee and incentive fee. A Buyer must understand how a target recognizes revenue under their various contracts and due diligence procedures should focus on ensuring that the target’s revenue is accurately recognized in accordance with ASC 606, “Revenue from Contracts with Customers.” Under the standard, for each contract companies must:
- Evaluate the contract to identify specific performance obligation(s)
- Determine the transaction price
- Allocate the transaction price to each performance obligation based on the standalone selling price of the goods or services
- Recognize revenue as the performance obligation(s) are satisfied, which could occur over time or at a point in time, depending on the nature of the performance obligation
Through diligence procedures, the Buyer should seek to understand if the revenue recognition practices of the target differ from their current policies for similar contracts as this would have to be harmonized either during purchase accounting or post-transaction. Improper accounting treatment of costs, such as pre-contract and fulfillment costs or misallocation of the transaction price due to miscalculation of the standalone selling price could result in a misstatement of revenue and an inaccurate valuation of the target.
Revenue under long-term fixed price contracts is usually recognized using the percentage of completion method. This method requires the use of significant judgment and estimates regarding contract value and estimated costs at completion. All too often, acquirers are surprised after the fact by significant loss contracts or contracts that do not meet profitability expectations due to inaccurate judgements or failure to reevaluate financial positions throughout contract performance.
When reviewing estimates at completion (EACs), the due diligence team should consider that estimated contract value at completion may include amounts that are uncertain, associated with for example award fees, change orders, or claims. Failure to recover such amounts will directly affect profitability. Therefore, undefinitized contract values should be specifically reviewed for likelihood of recovery. The AICPA Audit and Accounting Guide, ” Federal Government Contractors” and ASC 912, “Contractors – federal government” (in combination with ASC 606 and ASC 340-40, Other Assets and Deferred Costs—Contracts with Customers), provide guidance on estimating revenue at completion for financial statement purposes as well as guidance on evaluating appropriate revenue recognition practices under contract scenarios.
A related consideration the due diligence team should evaluate is the realizability of capitalized contract fulfillment costs under ASC 340 to ensure amounts are recoverable under specific contracts and or specifically identifiable anticipated contracts.
Estimated costs to complete a contract also require significant scrutiny. Material costs should be assessed by a review of incurred costs to date, purchase commitments, and an estimate of commitments required to be placed. Direct labor may be evaluated by comparing incurred costs against budgeted costs to date and projections of future costs. Significant productivity improvements assumed should be evaluated. Indirect costs to complete should be evaluated against current estimates of future indirect costs included in provisional and forward pricing rates. In addition, smaller or immature companies may not have sufficient resources or procedures to accurately estimate contract completion costs and the diligence team should evaluate the target’s capabilities in this regard.
Contract billings and funding should be evaluated, with the contract history being reviewed to ensure records and documentation, such as contract modifications increasing funding or contract value are available. Due diligence procedures should include verification that the work was performed to support billings to date.
Inquiries should be made regarding contracts in a loss position and the reasoning for the situation. While this is most common among fixed-price contracts, T&M and cost-type contracts could also be in a forward loss position. For example, when contractual indirect rate caps are lower than actual indirect rates on a cost-type contract, or when personal with a higher labor cost are utilized on a T&M contract, and those amounts exceed the cost considered in the estimated labor rate.
Gross margin percentages should be reviewed against historical margins on similar programs. Additionally, the due diligence team should determine if any EAC adjustments have been made that would significantly affect current-year earnings. Identifying such adjustments are critical, if the parties have agreed on a purchase price based on a multiple of current year earnings.
Unbilled Receivables
Unbilled receivables should be evaluated by understanding the component pieces, including but not limited to:
* fee withholdings,
* retainages,
* revenue recognized in excess of contract value or funded value (risk funding),
* requests for equitable adjustment,
* unpriced change orders, and
* differences between provisional, forecasted, actual indirect rates.
Revenue recognized in excess of the base contract value should be evaluated for probability of recovery. The due diligence team should evaluate the status of incurred cost submissions for indirect costs and any disputes between the contractor and the government regarding cost allowability. The team also should consider whether contractual indemnification should be obtained for significant risks and exposures.
Contingent Liabilities
Significant contingent liabilities can result from failure to comply with government regulations. Due diligence teams should inquire about cost allowability, cost accounting standards (CAS), compliance with the Truthful Cost or Pricing Data Act (formerly the Truth-in-Negotiations Act “TINA”), and price risks for Federal Supply Schedule (FSS) contracts, and understand the nature and position of any existing disputes regarding the treatment of costs under existing proposals and contracts.
Cost Allowability
Cost-type and other flexibly priced contracts are subject to the cost allowability provisions set forth in FAR Part 31. In many cases, final indirect rates can be settled many years after the costs are incurred. The team should identify years that remain open and obtain an understanding of the issues being raised as well as the adequacy of associated recorded reserves. Defense Contract Audit Agency (DCAA) (and other agency auditors) audit reports and correspondence should be reviewed to identify potential issues. The target company’s historical track record of submitted rates versus final settled rates can be analyzed to help assess potential risks associated with open years.
Cost Accounting Standards
Government contracts that meet certain criteria are subject to CAS. These standards govern the cost accounting practices used for measuring costs, assigning costs to accounting periods, and allocating costs to final cost objectives. Failure to comply with CAS or to consistently follow disclosed practices for estimating and recording costs can result in unilateral price adjustments by the government on existing contracts.
Additionally, the contractor is required to notify the government of any changes in cost accounting practices and provide a cost impact proposal identifying any effects on CAS-covered contracts. The due diligence team should review the acquisition targets’ CAS disclosure statement and correspondence with government auditors/DCAA and the administrative contracting officer to understand the potential for CAS noncompliance. Discussions should be held with company personnel to determine if cost accounting practice changes have been proposed and the impact of such changes should be understood.
Truthful Cost or Pricing Data Act
Under the Act, contractors are required to submit current, accurate, and complete cost or pricing data for negotiated procurements in excess of $2,000,000. Failure to comply with the Act can result in unilateral price reductions by the government, long after the contract has been awarded or even completed. The due diligence team should inquire whether the government has made allegations of defective pricing under the Act.
Unallowable Costs
Due diligence teams should be aware that certain costs related to an acquisition are unallowable for reimbursement on government contracts. For example, depreciation of asset step-up and amortization of intangible assets resulting from a business combination are unallowable in accordance with FAR 31.205-49 and FAR 31.205-52. Termination payments in excess of normal severance pay and “golden handcuff payments” (where special compensation is paid contingent on the employee remaining with the contractor for a specified period of time) are unallowable in accordance with FAR 31.205-6(1). Also, the U.S. Department of Defense’s FAR Supplement (DFARS 231.205-70) makes external restructuring costs in excess of $2.5 million unallowable unless the contractor can demonstrate that the present value of the net savings from the restructuring exceeds the costs by a ratio of 2 to 1 or greater. External restructuring costs include non-routine activities to combine facilities, operations, or workforces that affect more than one of the companies now under common control.
Business Systems
Essential to conducting any financial due diligence is gauging the ability to rely on the financial information retained within the target’s accounting and related business systems. An assessment of the target’s business systems, including their capability to support business objectives and provide accurate and complete reports of operations, should be a focus of the due diligence team. When conducting due diligence procedures for government contractors, specifically those servicing the Department of Defense, it should be determined if the target is subject to and able to comply with DFARS 252.242-7005 “Contractor Business Systems.” This requires that applicable business systems (Accounting, Estimating, Purchasing, Earned Value Management, Material Management, and Property Management) adhere to their “system criteria” and be free of any significant deficiencies. Systems found to possess a significant deficiency are subject to corrective action plans and potential payment withholds until the deficiency has been remediated to the Contracting Officer’s satisfaction.
Along with evaluating the capabilities of the target’s business systems for reporting purposes, if the target has DFARS business systems requirements, due diligence teams should be aware of the status of those systems and determine the risk of failing a DOD audit in their current state.
Cybersecurity
While cybersecurity continues to grow as a key risk area for companies of all types in all industries, government contractors face particular risks in that they must comply with increasing contractual requirements from various federal agencies. Government contractors may handle a variety of sensitive information, ranging from personal and health information to covered defense and export-controlled information. Broadly defined as controlled unclassified information (CUI), federal agencies are developing requirements for contractors to implement and provide assurance on the effectiveness of information security controls to protect CUI as well as rigorous incident reporting requirements for the occurrence of “cyber incidents” that may have impacted CUI.
Due diligence teams should understand the types of information the target is receiving or developing under its contracts, the applicability of cybersecurity requirements, and the status of the target’s information/cyber security program to ensure that it aligns with contractual requirements, which may differ between customer agencies. A company’s failure to implement the required controls may impact their ability to win new business and could potentially present the risk of a False Claims Act violation under existing contracts.
Key and Cleared Personnel
Certain contracts may require that specific personnel, with skills or experience essential to the work being performed and who are included in the proposal, maintain their availability to perform the work under the contract. Contracts may contain clauses that require the contractor to provide advance notice and justification, including information in sufficient detail to permit evaluation of the impact on the program, and obtain Contracting Officer approval prior to diverting these individuals to other projects. Changes to key personnel post proposal submission and pre-award may impact the agency evaluation or serve as grounds for a Bid Protest. Additionally, for contractors performing work on classified programs, sourcing and retaining cleared personnel is essential to the company’s ability to perform to the contract and continued growth. However, the available talent pool can be impacted by numerous factors outside of the control of the company, presenting a risk to performance.
The due diligence process should include evaluation of the target’s contracts and contractual requirements regarding their use of key and cleared personnel. If deemed a pertinent risk, the due diligence team should assess the potential impact that losing key personnel and the ability to retain cleared personnel in the near or medium term may have on the contractor’s ability to win new work or increase recruitment costs.
Federal Supply Schedule
Some companies contract with the government through the General Service Administration’s FSS, whereby they agree to sell a commercial item at a stated price. Under these contracts, the government is granted the most favorable price for that class of customer and companies are required to submit periodic sales reports and remit associated fees. These contracts include a price reduction clause whereby the government obtains a retroactive price reduction when the company in certain circumstances offers a lower price to a similar class commercial customer during the life of the contract. The team should assess what price reduction risks exist and the procedures for tracking sales under FSS contracts.
Small and Disadvantaged Business Set Asides
The Small Business Administration (SBA) has various programs that support small and disadvantaged businesses to provide these businesses with opportunities to compete in the federal marketplace. While these programs can help establish a beachhead in the federal marketplace and assist eligible businesses to grow quickly, a company may “graduate” from these programs after reaching a certain size, which can impact their eligibility for specific set-aside contracts. Due diligence teams must understand if a company is over-reliant on opportunities provided by SBA programs and determine if the company has demonstrated the ability to continue to grow by winning in “full and open” competition without the assistance of set-asides.
Contract Novations
Federal law prohibits the transfer of government contracts from the contractor to a third party. However, the government may recognize a third party as a successor to a government contract through a process known as a novation. Under a novation, the seller guarantees contract performance, the buyer assumes all contract obligations, and the government recognizes the contract transfer. As part of the novation agreement, the parties agree that the government is not obligated to reimburse the parties for any costs that increase as a result of the transfer.
The novation process can be administratively burdensome and time-consuming. The purchaser should consider including language in the definitive agreement that will provide it with the contract’s economic benefits until the novation agreement is executed. Stock acquisitions normally do not require a novation because the legal entity that is a party to the government contract has not changed.
When it is determined that financial risks related to government contract compliance exist creating potential contingent liabilities, the Buyer can mitigate this risk by drafting an agreement that addresses the potential negative outcomes and limits its exposure. Actions in this regard could include, but are not limited to, the following:
Definitive Agreements
Risks identified during due diligence can be mitigated in the definitive agreement. Some identified risks may result in renegotiation of the purchase price. Examples could include a shift in business from recurring negotiated production contracts with predictable earnings to competitive new programs with lower margins. This type of risk may be identified by a detailed review of backlogs, proposals, and future sales prospects.
Other due diligence findings that could affect the business’ valuation include identification of significant one-time adjustments, which skew normalized earnings. In addition to renegotiation of the purchase price, a number of contractual clauses can be used to mitigate risk, such as purchase price adjustment clauses, representations and warranties, excluded liabilities, and indemnifications.
Purchase Price Adjustments
In many cases, the definitive agreement includes a purchase price adjustment provision equal to the difference between an interim and closing balance sheet. In other cases, the final purchase price is based upon a specified dollar premium over the acquired company’s net book value at closing. Either of these two scenarios requires submission of a closing balance sheet. The definitive agreement will provide the basis on which the closing balance sheet is prepared. In many cases, the basis will be U.S. generally accepted accounting principles as modified by specific “accounting instructions” included in an exhibit to the definitive agreement.
As discussed earlier, revenue recognition and the related balance sheet impact under long-term government contracts require estimation and the use of significant judgment, as does the accrual for contingent liabilities associated with non-compliance of government regulations. The buyer and seller may take significantly different views regarding these estimates and their resulting impact on the closing balance sheet. Accordingly, strategic advantage can be gained in thoughtful negotiation of the accounting instructions used to calculate the closing balance sheet.
The inclusion of accounting instructions may reduce the risk of purchase price disputes between the buyer and seller. For example, the accounting instructions could specify that the purchaser cannot reassess the seller’s judgment regarding EACs. Alternatively, the parties could reach advance agreement on the contract gross margin percentages to be used when preparing the closing balance sheet.
In addition, the accounting instructions could specify that reserves be calculated as a specified percentage of balances over a certain threshold. The buyer should review the risks and judgmental areas identified in the financial due diligence to determine what unique accounting instructions may be warranted.
Representations and Warranties
Based on the due diligence results, the purchaser should consider specific representations and warranties to cover risk areas such as compliance with TINA, CAS, the Civil and Criminal False Claims Acts, and so forth. When drafting representations and warranties, the purchaser should consider that government allegations of wrongdoing can occur many years after the acquisition has closed.
Excluded Liabilities and Indemnifications
Various risks identified during due diligence can be mitigated by excluding liabilities or indemnifications. For example, the parties could agree that the seller retains liability for the ultimate resolution of a defective pricing matter. Similarly, the parties could agree that the seller retains liability for any negative impact resulting from the settlement of open rate years post-transaction. Under an indemnification agreement, the seller agrees to reimburse the buyer for costs incurred related to specified items. For instance, the buyer could be indemnified against any loss resulting from a specified government investigation.
Indemnifications are normally subject to ceiling amounts agreed to by the parties. Purchasers should consider the seller’s financial ability to pay for the cost of any issues that arise from indemnifications.
Strive to Mitigate Risks
The unique risks of government contractors need to be thoroughly reviewed during due diligence and considered in valuing the transaction. An integrated due diligence team with financial, operational, legal, IT, and government contracting expertise is critical to help ensure transaction risks are properly considered. Early within the diligence process it is important to ensure that the integrated diligence team members establish areas of focus, coordinate to evaluate identified risk areas, and communicate findings in a timely manner. It is essential that the integrated diligence team understand the value of the acquisition to the Buyer which will provide context on the pricing strategy, as well as the level of diligence to be focused on certain areas. Purchasers also should consider how to structure the definitive agreement to mitigate the risks discussed.