United States: Disruptive Changes On The Horizon For Federal COTS Software Supply

Last Updated: February 24 2015
Article by Albert B. Krachman

Government Contracts

Action Item: Firms making commercial off-the-shelf ("COTS") software sold to the federal government, or reselling COTS software to the federal government, should respond to the SBA's recent proposed rule or risk a loss of market share.

Commercial software manufacturers and certain federal resellers could find their federal business significantly impacted by an SBA Proposed Rule published recently at 79 Fed. Reg. 77955, December 29, 2014. If adopted without changes, the Rule will incentivize the government to buy commercial item software through small business set asides under NAICS Code 511210, which is currently limited to vendors under a size standard of $38.5M Average Annual Receipts over the prior 3 years. To do this, the SBA will be granting individual waivers of what is known as the "non-manufacturer rule" for certain software that meets the regulatory definitions. The waiver means that an eligible small business may resell software manufactured by a large business under the non-manufacturer exception to the general rule on limitation of subcontracting. While proposed for revision, the general rule currently requires a small business prime contractor on a set aside contract to self perform 50% of the manufacturing costs, excluding materials costs. The pending revision will change the subcontracting formula from a cost based calculation to one based on the amount paid to the prime contractor and similarly situated entities.

Importantly, the Rule does not extend this preference to contracts that acquire newly created, custom designed software. Also excluded is software sold through subscription services, remote hosting of software, and data or other cloud-based applications not on government servers. These latter contracts would be deemed service contracts, making it difficult, if not impossible for a small business reseller to sell software manufactured by a large firm on a set aside contract. There are also provisions that govern software and service combinations, and dictate that the value of the services, in comparison to the value of the code, determines whether waivers will be granted. 

If the Rule becomes final without change, it is likely to have several public and private sector impacts in the software vertical. The government will likely increase the use of set aside contracts under NAICS Code 511210 to acquire commercial item software that is uploaded to government servers and run from government servers because they can credit those purchases against their small business goals. Where the government has a choice of buying the same application either on an uploaded basis or as a service through the cloud, it will be incentivized to use the uploaded format, again because it can receive set aside credit if it buys from an eligible small business on a set aside contract.

Manufacturers who sell significant volumes of commercial off the shelf software to the federal government, through resellers or directly, and who either are or plan to be substantially in the cloud, may be disadvantaged by the Proposed Rule if promulgated in its current form. As a hedge, those firms should maintain their code upload delivery models.

Manufacturers would also be well advised to diversify their sales channels and examine their reseller relationships to be sure there are multiple relationships with small business vendors who are likely to remain under the $38.5M size standard for more than three years in the future. They should strategically plan for exploiting this channel and be prepared to assist the small businesses with the waiver process, which will be done on a contract-by-contract basis. Manufacturers may even consider strategic alliances, mentor protégé relationships, and/or investments in these firms because they are likely to realize significant growth. The change might also implicate manufacturers' small business subcontracting plans. Large business resellers of commercial item software are likely to lose business and market share in this segment.

Even though this is a Proposed Rule, it stakes out the legal position of the SBA on this issue. Even before the Rule takes effect, the SBA may grant a requested nonmanufacturer's waiver if a qualified vendor files the right application. So it would be prudent for affected businesses to start looking at qualified small resellers early on.

In its current form, the Proposed Rule creates potential winners and losers. Clearly, companies who stress COTS cloud solutions could be adversely impacted by the Rule. It is unclear why cloud service is being disadvantaged, and it is also unclear how one will compute the fair valuation of software versus services for purposes of obtaining the waivers. It would be prudent to comment on the Rule rather than to remain silent to either protect existing market share or to stake out growth potential. Comments are due by a February 27, 2015, deadline.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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