Coming to America Pt1 - The Importance of NAICS Codes

Introduction

There are many compelling reasons to consider expanding your European-based business by establishing a presence in the United States. If you are considering this option, you have already justified that plan. However, there are many unique differences between European operations and laws and those of the USA. One of those differences is the rules for small business contracts and the associated NAICS codes.

If your strategy to expand into the United States market includes selling to the US Federal Government, it is critical to understand NAICS codes and how they can impact future revenues and growth. Additionally, and maybe more importantly, there are circumstances in which your successes can damage future revenue opportunities and cash generation.

A company had an 18-year history of delivering support and upgrade services to the US Air Force. Every five years, a new 1-year contract with four additional yearly options was awarded. At the end of each 5-year period, the contract was opened for a recompete. As is typical, the incumbent is in a strong position to win the renewed contract, and often, they do (assuming their performance was acceptable).

It sounds ideal, in this example, $6 million to $12 million in yearly recurring high-margin revenue for many years with no end in sight. Repeating five-year contract terms with consistent monthly revenue recognition and cash generation is understandably comforting for any business. Furthermore, they can be used to secure loans and additional investments.

Sadly, the lucrative contract came to a screeching halt when the government decided that the contract would become a small business set aside. The company, due to its growth successes, would no longer be eligible to compete on the contract.

Small Business Set-Asides

The federal government aims to award more than 20% of prime contracts to small businesses. In 2021 that amounted to over $154 billion. It is a revenue source that should be appealing to any company that has a product or service that the government needs. Additionally, the US Federal Government is a prompt payer of invoices, improving the speed of cash which is always beneficial.

So how do you qualify to bid on a set-aside contract? It is quite simple, you either have to be below a prescribed number of employees or have revenues lower than a defined threshold. However, the term small business is quite contradictory. Your organization may qualify as a small business even with thousands of employees and tens of millions in existing revenues. The threshold limits are determined by the contract NAICS code.

What is a NAICS Code?

A NAICS (pronounced Nakes) code is part of the North American Industry Classification System. Within NAICS, each industry is assigned a unique code (hence the NAICS code). The system uses a hierarchical structure starting with a general group description. For example, 54 indicates Professional, Scientific, and Technical Services, within which four-digit codes indicate sub-sectors. Computer Systems Design and Related Services fall under group number 5415.

The subsector is further divided into more specific products and services, where you will find the 6-digit contract NAICS code, e.g., 541511 – Custom Computer Programming Services, and the employee and revenue thresholds to qualify for a small business contract. For 541511, the annual revenue limit is $30 million. There are nuances to how your own revenues are defined that will be discussed in a later post. However, it is not simply your last year's declared revenues.

How Do I Get a NAICS Code?

NAICS codes are self-determined by a business, and you may claim an unlimited number of codes. The number assigned to a planned contract is determined by the contracting authority. Understanding the rules of small business contracting and the NAICS code could be a crucial component of your expansion strategy; that strategy should consider the possible downside of your own business growth.

Warning, if you plan to buy an existing US business that relies on small business set aside revenue, the change of ownership will change the company’s small business size determination and possibly lead to the elimination from competing on small business contracts. What does this specifically mean for private equity portfolio companies that plan to make the trip across the Atlantic? You can find the answer in Part 2 of this topic.

Disclaimer

I am not a contract lawyer, and the information in this article should not be considered legal advice. The information should be used as a background primer only.