The survival rates show that around 40 percent of new entrants exit the market for federal contracts after three years, around 60 percent after five years, and only about one-fifth of new entrants remain in the federal contracting arena after 10 years. These survival rates are fairly consistent with the results from other studies that calculate the survival rates of new entrants in other sectors of the economy and/or at different time periods.
Although these results [also] suggest that small businesses tend to have higher survival rates than their non-small competitors across all federal agencies, the low graduation rates of small businesses that survived for 10 years rings alarm bells over the efficacy of small business set aside programs. Across the samples from 2001 to 2006, the graduation rates of small businesses consistently decrease. While in 2001, around 16-19 percent of small businesses that survive 10 years graduate from small business status, and in 2006, around 6-8 percent of small businesses that survive 10 years graduate from small business status. This could imply that small businesses face a perverse incentive regarding their business model where since they have safety nets when they remain small, they could be avoiding normal business growth trajectories to maintain the advantages associated with small business status.
That was from the CSIS paper, “New Entrants and Small Business Graduation in the Market for Federal Contracts.” I think the results are quite believable since it confirms most people’s intuition that while there are plenty of opportunities to start a small business in the federal contracting space, it is rather difficult for them to graduate into the mid-tiers — let along the majors.
To put that together for you, if about 1/5 of small businesses survive for 10 years, and perhaps 5-20 percent graduate from small business status, then a new small business can expect a 1-4 percent chance of scaling out of small business. But that is pretty difficult to gauge, as there are various rules which create a wide margin for what is considered a small business:
The thresholds vary and can range from 250 to 1,500 in average employment or from $750,000 to $38,500,000 in average annual receipts. Thus, these metrics can be subjective in some cases. For instance, during the analysis for this paper, the study team found a case where a vendor that made over 6 million dollars in annual 2011 revenue was classified as small because it had less than 100 employees. Second, some firms span more than one sector and may qualify as small within one sector and not within another, creating policy implementation challenges.
In any case, a 1-4 percent chance of graduating from a small business isn’t exactly enticing to investors. But federal contracting isn’t like Silicon Valley where you tend to see a barbell with big time winners and go-to-zero losers. Instead, you’ll probably find that many companies that exit the federal market have sold themselves off, or continued as a thriving subcontractor, or moved into the commercial space. I expect that these companies provide a steady stream of returns or pay out well even if their valuation doesn’t go through the roof.
This structure probably reflects the industrial era processes used by government to award contracts and determine pricing. Things look more predictable overall. Known services are rendered according to known methods. There is less of a place for “irrational exuberance” associated with new value-enhancing propositions that could sweep aside an incumbent and create a major player. SpaceX, of course, appears to be an exception to this rule — but it started with enough capital such that it was never a small business.
My working theory is that small businesses in federal contracting have less room to build a solution on private financing because government will want to pay for the marginal cost by demanding cost/pricing data. But this kind of buyer neglects the fixed up-front costs, as well as the very real risks of bring wrong. I think small businesses in the federal space are less willing to bite that bullet, neglect the sunk costs, and focus on rapidly scaling with low margins. Rather, they try to sell as a commercial item or license the product at high margins, or they work on government-directed activities.
Here’s a little extra on the scale of small business contracting from the Office of Federal Register:
In fiscal year 2017, small businesses received $105.7 billion in Federal contracts, including $42.0 billion in set-aside contracts for small businesses.
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