Under the Small Business Administration’s “present effect rule,” an LOI can create affiliation between parties negotiating a potential sale or merger.
Whether or not an LOI in fact creates an affiliation is a fact-intensive inquiry.
Among key considerations are the circumstances surrounding the negotiations, the circumstances surrounding the due diligence, and, as a practical matter, the language of the LOI.

In two recent decisions, OHA discussed some of the factors that may differentiate whether an LOI triggers SBA’s “present effect rule” and creates an affiliation between parties negotiating the acquisition of a small business. In Size Appeal of Telecommunications Support Services, Inc., SBA No. SIZ-5953 (2018), OHA determined that the LOI did not create an affiliation, and in Size Appeal of Enhanced Vision Systems, Inc., SBA No. SIZ-5978 (2018), OHA found that the LOI did create an affiliation and drew several distinctions between the two fact patterns.

SBA’s “Present Effect Rule”
The SBA’s “present effect rule” states that, in determining size, SBA considers agreements to merge, “including agreements in principle,” to have a “present effect on the power to control a concern.” 13 C.F.R. § 121.103(d)(1). By contrast, “Agreements to open or continue negotiations toward the possibility of a merger or sale of stock at some later date are not considered ‘agreements in principle’ and are thus not given present effect.” 13 C.F.R. § 121.103(d)(2). If an LOI between two concerns contemplating an acquisition or merger is an agreement in principle, those two concerns are considered affiliated. For a small business concern, often the target in such transactions, and the buyer, entering into such an LOI may have significant implications as it may render the concern ineligible to bid on small business contracts.

Telecommunications Support Services, Inc.
In the first case, Telecommunications Support Services, Inc., OHA reversed an SBA Area Office’s size determination that a buyer and seller were affiliated under the “present effect rule.” OHA concluded that the LOI in question was not an agreement in principle, finding that the LOI did not trigger the present effect rule. Telecommunications was the first important decision issued in many years by OHA addressing this subject. In this particular case, OHA found that the LOI was merely “an opportunity to evaluate an opportunity,” and had only set forth the general terms and conditions under which the buyer would be willing to purchase the seller. Although many factors went into OHA’s conclusion, among the most important was that, for example, the LOI established a price but it stipulated that the price was conditional on the seller meeting certain financial targets. OHA also emphasized that the LOI was conditioned on the buyer’s extensive due diligence review and stated that the LOI allowed for either party to withdraw from the agreement. Furthermore, OHA considered the fact that negotiations broke down when problems arose, and they did not resume until the seller improved its financial condition. Also, OHA noted that the deal was not closed during the timeframe established by the LOI, adding that the seller sought, and could have accepted, offers from other buyers after the period of exclusivity ended.

In finding an absence of affiliation, OHA concluded, based on the totality of the circumstances, that “it would confound logic to hold that an agreement in principle existed at the time to determine size, yet that same agreement could fall apart after the date to determine size based on the unilateral actions of one of the parties.”

Enhanced Vision Systems, Inc.
Approximately four months later, OHA issued a second important decision, Enhanced Vision Systems, Inc. In this new case, OHA agreed with an SBA Area Office determination, finding that the LOI at issue was an agreement in principle which triggered the “present effect rule.” In determining that there was an agreement in principle, OHA considered the fact that negotiations began weeks, if not months, before the parties signed the LOI, and that the parties had negotiated the price before signing. Additionally, OHA looked at the nature of the due diligence review, finding that the LOI required only a confirmatory due diligence review, and that the purchase did not appear to be conditioned on the results of that review. OHA also noted that, although there appeared to be a breakdown in negotiations, it lasted only a week over the holiday season, and the parties in fact were committed to closing the deal. For these and other reasons, OHA agreed that the LOI was an agreement in principle and the parties were affiliated.

Avoiding affiliation between a potential buyer and seller can be of great importance where one of the parties seeks to maintain its small business size status during the period of a sale or merger negotiation. As these two recent OHA cases remind us, the determination of whether an LOI creates affiliation can be an intensely fact-specific inquiry that depends on the totality of circumstances. These two OHA cases, issued close in time and reaching opposite conclusions, provide valuable new guidance in structuring and executing negotiations to optimize the results of an acquisition.