The U.S. Department of Defense (“DoD”) is continuing an exciting and growing trend to give contract award preference to 100% employee-owned S-corporations. A significant step in furtherance of this development is that at the end of May this year, the DoD issued a proposed rule for comment. The goal of the program is to allow businesses with an Employee Stock Ownership Plan (“ESOP”) to get preferential treatment in certain DoD follow-on contract awards.
The proposed rule will give contracting officers the authority to award one sole-source, follow-on contract for the “continued development, production, or provision of products or services that are the same or substantially similar to those procured under previous contracts awarded by or for DoD to contractors that meet the definition of a qualified business.” A “qualified business” is defined as a 100% ESOP S-corporation.
The original pilot program from the DoD to show preference for ESOP companies was implemented on November 8, 2022, which allowed companies that had won disadvantaged business set aside contracts to be eligible to win follow-on contracts under the same disadvantaged business set aside qualifications if 100% of the stock of the business went to an ESOP. To date, eight businesses are participating in the pilot, six of which are small entities.
The DoD’s growing preference for ESOP companies underscores several strategic imperatives essential to national security and economic resilience that show what an important role ESOP companies can play in our national defense:
- First, ESOPs tend to exhibit enhanced employee morale and retention rates, critical factors in industries requiring specialized skills and continuity of operations. By prioritizing these companies, the DoD aims to mitigate risks associated with workforce turnover and maintain institutional knowledge vital for mission-critical projects.
- Second, ESOPs typically foster a culture of innovation and efficiency. Research indicates that employee-owned firms often outperform their counterparts in terms of productivity and operational excellence. This advantage is particularly pertinent in defense contracting, where technological innovation and rapid adaptation to evolving threats are paramount.
- Last, ESOPs align with governmental objectives of promoting inclusive economic growth and reducing income inequality. By empowering employees as stakeholders, these companies contribute to a more equitable distribution of wealth and opportunities, thereby strengthening the socioeconomic fabric of communities nationwide.
While the DoD’s increasing preference for ESOP companies represents a welcomed advancement stance, several regulatory and contractual considerations merit attention. Contracting officers tasked with evaluating bids from ESOP firms must ensure compliance with stringent federal acquisition regulations (“FARs”) and assess the company’s capacity to meet specific performance criteria.
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Contracts will continue to be awarded based on merit, and companies must still demonstrate excellent performance to be awarded contracts. While ESOPs offer compelling advantages, contract awards must still prioritize merit and capability above all else to uphold the integrity of the procurement process. These practices must uphold principles of fair competition and nondiscrimination. If two contractors with equal qualifications are being considered for a contract, the employee-owned contractor may receive preference in awarding the contract.
The proposed rule, specifies that—
- The contracting officer is the only individual with authority to submit an application to participate in the pilot program; so, a government contractor must work through the contracting officer to become eligible;
- Contracting officers may only award contracts to contractors that meet the definition of a qualified business; meaning only 100% ESOP S-corporations that have already received a contract award that is being reissued/recompeted/or issuing a follow-on award are eligible;
- Contracting officers may only award one sole-source, follow-on contract to a qualified business for each predecessor contract, unless a waiver is obtained; and
- There is a limit (subject to a waiver provision for certain circumstances) where a qualified business will not be allowed to subcontract more than 50 percent of the contract revenue to subcontractors that are not themselves qualified businesses (unless that subcontract is technically for purchased products that are not available from another qualified business).
- The opportunity to award contracts under the pilot program expires on December 27, 2029.
This proposed rule also imposes a new reporting requirement to evaluate the pilot program after it ends. The proposed rule states that “not later than 30 days after the end of the period of performance of the contract, contractors participating in the pilot program will be required to submit to the contracting officer the following information: (1) the number of years the contractor has been wholly-owned by its employee stock ownership plan; (2) the contractor’s challenges in attracting and retaining a talented workforce; (3) challenges the contractor experienced due to its corporate ownership structure that hinder its ability to contract with DoD in order to scale its technologies and capabilities due to its corporate ownership structure; and (4) challenges the contractor experienced due to its corporate ownership structure in obtaining capital necessary to bridge funding gaps, for example, between prototype demonstration and full-scale development.”
The DoD’s proposed new pilot program opens enhanced opportunities for ESOP companies. The comment period is approaching and those in favor of this program are asked to add their comments. Implementation of the pilot program is a great opportunity for employee-owned companies to continue to demonstrate the strengths of the employee ownership structure, performance and positive impact on the country’s defense readiness and support.
Michael McGinley is a Managing Director at Prairie Capital Advisors, Inc. He can be contacted at 404.809.2443 or by email: mmcginley@prairiecap.com.
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