An Early Start Of Specialized Due Diligence Is Key To Successful M&A Transactions Involving Government Contractors - Part II

Friday, July 1, 2011 - 00:00

Editor's Note: The first part of this article, which appeared in the June issue of The Metropolitan Corporate Counsel, discussed understanding "materiality" and the scope of information needed for due diligence. It can be found at http:// www.metrocorpcounsel.com/current.php?artType=view&EntryNo=12386.

Valuing the Seller's Government Contracts Backlog

Perhaps the most important objective of a buyer during due diligence is identifying a purchase price that reliably estimates the seller's assets and liabilities. Many government contractors obtain most, and sometimes all, of their revenue from their contracts with federal agencies, making the valuation of these assets a principal focus of due diligence. Although this valuation is primarily a business, as opposed to legal, function, government contracts possess a number of unique legal features that can frustrate a buyer's valuation efforts if not properly understood and taken into account:

First , the value of a seller's government contracts often will not be what the seller identifies as the "total value" or "awarded value" of those contracts. The government uses a variety of contract vehicles to acquire goods and services, including:

• Fixed-Price contracts, which provide the seller a fixed amount negotiated in advance for the specific work to be performed;

• Cost-Reimbursable contracts, which allow for the reimbursement of certain seller costs plus a fee (more on how these fees are calculated and earned later); and

• Indefinite-Delivery/Indefinite-Quantity, or "ID/IQ," contracts, which permit the government to order goods and services in the future as needed, but do not commit the government to purchasing more than a minimum, often nominal, amount.

Valuing fixed-price contracts is more of a straightforward task relative to the other two types, but there remain a number of traps for the unwary. For one, most fixed-price contracts are divided into a one-year base period followed by several one-year options. This is a function of the fact that most government contracts are funded through annual appropriations from Congress, and the government has broad discretion whether or not to exercise a given option. Predicting the likelihood that the government will exercise options is primarily a business exercise, but it often should be informed by a legal assessment of the seller's compliance with contract requirements and any actual or potential disputes that may exist. Another challenge in valuing fixed-price contracts is the government's right under the standard "Changes" clause to alter the scope of the contractor's performance. Assessing when the government has formally or constructively issued a change, and how such a change may increase or decrease the compensation the contractor can expect to receive, is essential to a proper valuation of any given contract.

Valuing cost-reimbursable and ID/IQ contracts is more complicated. ID/IQ contracts are, by definition, "indefinite." The government agrees to purchase a minimum amount stated in the contract, but the actual amount may vary considerably. Also, for certain large-dollar requirements, the government awards multiple ID/IQ contracts for the same goods or services, and then separately competes orders for those goods and services among the holders of the ID/IQ contracts. Understanding the government's ordering history and the competition requirements that may limit future orders is therefore critical.

Cost-reimbursable contracts similarly do not have a "price"; instead, the amount that the government will ultimately pay depends on the actual, "allowable" costs incurred by the contractor. These contracts are awarded only where - and precisely because - the actual level of effort to be performed cannot be reliably estimated. Moreover, whereas fixed-price contracts are usually fully funded through the base year or the most recently exercised option, cost-reimbursable contracts are often incrementally funded. In other words, the government agrees to reimburse a contractor for its costs up to a given amount that may be far below the total estimated cost of the contract, but retains the discretion not to fund the contract further if it so desires.

Second , cost-reimbursable contracts are further subject to a host of legal rules that affect whether and how certain costs will be reimbursed. As a general matter, the contracts provide that only allowable costs, as defined by the Federal Acquisition Regulation (FAR), may be invoiced to the government, and that penalties may be assessed if "expressly unallowable" costs are submitted for payment. Certain contracts may also be subject to the Cost Accounting Standards which require contractors to adopt, disclose and consistently follow detailed accounting practices. Moreover, individual contracts may contain a variety of special cost allowability provisions.

A seller may invoice and be paid its costs on a regular basis, but these invoices are subject to review by government auditors, often the Defense Contract Audit Agency (DCAA). DCAA can and will question the payment of costs long after they are incurred. Currently, DCAA has backlogs of five years or more with respect to certain incurred cost submissions, meaning that potential disagreements relating to the allowability of certain costs might not have surfaced yet, and a seller may not know exactly what it will be paid on a given contract until years after the contract is completed. A careful review of the seller's incurred cost audits and correspondence with DCAA is therefore essential to valuing the seller's cost-reimbursable contracts, as is an understanding of any reserves the seller has taken to address anticipated disallowances.

Third , the "fee" that a seller earns on cost-reimbursable contracts may be determined through a variety of different mechanisms, including:

• "fixed" fee, i.e. , a negotiated fee that is fixed at the inception of the contract and does not vary with actual cost or schedule performance (but that may be adjusted based on changes to the contract's scope of work);

• "award" fee, i.e. , a fee based on a subjective evaluation by the government regarding the merits of the contractor's performance; and

• "incentive" fee, i.e. , an initially negotiated fee that is adjusted based on the contractor's actual performance using formulas tied to target costs and/or schedule milestones.

The key distinctions among the three types of fees are the variability of the fee actually paid to the contractor and the degree of discretion afforded to the government to determine the fee actually paid. Fixed fees usually vary only when the parties negotiate a new fixed fee, usually because of a change in the scope of the underlying work being performed. Award and incentive fees, by contrast, vary based on the contractor's performance. The government usually has no discretion regarding the amount of fixed or incentive fee paid (the former being fixed and the latter turning on a pre-negotiated formula), whereas award fee determinations are unilateral decisions made solely at the discretion of the government. Award fee decisions can be disputed, but typically they are only reviewable for abuse of discretion, for example, if a decision was arbitrary and capricious. Moreover, some contracts contain "Conditional Payment of Fee" clauses that permit the government to unilaterally reduce previously earned award fee based on certain performance failures ( e.g. , environmental, safety and health issues).

Finally , whether included in the contract or not, the government retains the right to terminate contracts, not only for a default by the seller, but also for the government's "convenience." In the event of a termination for default, the government may recover any increased cost incurred to hire and pay another contractor to complete the work. A default termination can also have serious repercussions for a contractor's ability to obtain future work, and, if sufficiently egregious, may even lead to a contractor's suspension or debarment from receiving new contract awards and new orders under existing contracts.

A termination for convenience, by contrast, permits the government to "walk away" from its contractual obligations. In the event of a termination for convenience, the contractor generally is entitled to reimbursement of the costs it has incurred prior to the effective date of the termination, as well as a fee calculated according to the percentage of work completed. Because of the broad discretion afforded to the government to terminate contracts for its convenience, the termination clause effectively operates as a de facto consent requirement for the transaction. In other words, if the government determines that the transaction is not "in the government's interest," or that the government's interests would be better served by recompeting the contracts immediately, the government could elect to terminate one or more of the contracts for its convenience.

Rand L. Allen , Chair of Wiley Rein's Government Contracts Practice, represents clients ranging from "middle market IT" and professional services firms to the nation's largest aerospace and defense contractors, in every aspect of government contracting, including bid protests, disputes, commercial litigation, terminations, mergers and acquisitions, "procurement fraud"/False Claims Act investigations, suspension/debarment and regulatory issues. He can be reached at (202) 719-7329. Daniel P. Graham , a Partner in the Government Contracts Practice, counsels and represents government contractors on a broad range of legal matters including commercial litigation, bid protests, claims preparation and litigation, mergers and acquisitions, compliance with ethics and procurement integrity laws, procurement fraud investigations and suspension/debarment proceedings. Mr. Graham has also assisted clients in performing due diligence for large transactions involving government contractors. He can be reached at (202) 719-7433. Kay Tatum , Chair of the firm's Corporate Practice, represents government contractor, communications, technology, financial services, insurance, health care provider and not-for-profit corporation and trade association clients in mergers, acquisitions, dispositions, joint ventures and complex commercial contracts. She assists clients in all phases of the transaction, from initial strategy to consummation, and has experience in a variety of public and private financing methods. Ms. Tatum can be reached at (202) 719-7368. Jeremy Schofer , an Associate in Wiley Rein's Corporate Practice, represents clients in communication, government contract and corporate transactions. He has extensive experience negotiating competitive cable franchise agreements and representing clients publicly before local governments. Mr. Schofer can be reached at (202) 719-4646.

 

Please email the authors at rallen@wileyrein.com, dgraham@wileyrein.com, ktatum@wileyrein.com or jschofer@wileyrein.comwith questions about this article.