Limitations on Subcontracting for Software Companies: The 50% Rule on Set-Aside Contracts
#small-business#set-asides#saas#federal-market
By Philip Luca — Founder of GovExpress; prior domain experience at Bloomberg Government and GovWin IQ.
Winning a small business set-aside comes with a condition that many first-time primes only read after award: the small business has to do a meaningful share of the work itself. That condition is the limitations on subcontracting, and for a software company that plans to lean on partners, resellers or cloud providers, it shapes how the deal can be structured.
This guide covers which awards the rule applies to, the percentages, what counts toward the limit, how compliance is measured and what happens when a prime misses it. The rules quoted here are from the SBA’s regulation at 13 CFR 125.6.
Which awards the rule applies to
Under 13 CFR 125.6(a), a small business must agree to the limitations on subcontracting to be awarded:
- a full or partial small business set-aside contract with a value greater than the simplified acquisition threshold,
- an 8(a) contract,
- an SDVOSB or VOSB contract,
- a HUBZone contract, or
- a WOSB or EDWOSB contract.
Paragraph (f) carves out set-aside contracts valued above the micro-purchase threshold but at or below the simplified acquisition threshold. The limitations also do not apply to subcontracts, except where a prime is relying on a similarly situated entity to meet them.
The solicitation will usually tell you whether the rule applies by including the FAR limitations on subcontracting clause. If you are bidding as a small business on any of the award types above, assume it does and read the clause.
The percentages
The limit depends on what the contract is for:
| Contract type | Most the prime may pay to firms that are not similarly situated |
|---|---|
| Services (except construction) | 50% of the amount paid by the government to the prime |
| Supplies or products (from a manufacturer) | 50%, with cost of materials excluded |
| General construction | 85%, with cost of materials excluded |
| Special trade construction | 75%, with cost of materials excluded |
Most software and IT work is bought under a services NAICS code, so the 50% services limit is the one a software company meets most often. Where a contract mixes services, supplies or construction, paragraph (b) says the contracting officer’s choice of NAICS code decides which limit applies, and only one limit applies to a contract.
Supplies from a nonmanufacturer follow a different test. Instead of a payment percentage, a nonmanufacturer has to supply the product of a domestic small business manufacturer or processor unless a waiver is granted. A software company reselling another company’s product on a set-aside should check that rule before quoting.
What counts toward the 50%
Three parts of the regulation change the arithmetic for a software company.
Similarly situated subcontractors count as you. Under paragraph (c), amounts a prime spends on a similarly situated entity are not treated as subcontracted, to the extent that subcontractor does the work with its own employees. A similarly situated entity is a subcontractor that shares the small business status the award was set aside for, such as another 8(a) firm on an 8(a) contract. The status has to match: the regulation’s own example is a WOSB prime that subcontracts more than half of a services contract to an SDVOSB that is not also a WOSB, and that prime is in violation.
Pass-through still counts against you. Work that a similarly situated subcontractor further subcontracts counts toward the limit. You cannot route work through a similarly situated firm that hands it to a large business.
Some other direct costs can be excluded. For services contracts, paragraph (a)(1) lets other direct costs be excluded to the extent they are not the principal purpose of the acquisition and small businesses do not provide the service. The examples in the regulation include airline travel, mass media purchases and cloud computing services. For a SaaS company running on a large commercial cloud provider, that exclusion matters: hosting costs that meet the test are not counted as work subcontracted to the cloud provider.
The regulation also treats independent contractors as subcontractors, counting toward compliance only if they are similarly situated. Employees obtained from a temporary agency, professional employer organization or leasing concern are treated as the prime’s own performance, except on staffing contracts.
How compliance is measured
Paragraph (d) sets the measurement period:
- Set-aside contracts. Generally the base term, then each option period.
- Multi-agency set-aside contracts. Where more than one agency can place orders, each order is measured over its own period of performance.
- Orders set aside under a full and open contract. Measured order by order, unless the order is competed among small and other-than-small businesses, in which case the limitations do not apply.
The contracting officer may also require compliance on each order under a set-aside contract, and may ask for evidence at any time during performance or at completion. The regulation lists invoices, copies of subcontracts or a list of the value of tasks performed as evidence. Compliance is treated as a matter of responsibility, not of size eligibility.
If you plan to sell through IDIQ task orders, expect to track this per order as well as per contract.
What happens if you miss it
The consequences are set out in paragraphs (e) and (h).
- Past performance. If an agency finds at the end of performance that the limit was not met, it must notify the contractor and give it a chance to explain extenuating circumstances. If the circumstances were within the contractor’s control, or none are offered, the agency may not give a satisfactory or higher rating for the relevant factor in the contractor’s evaluation. That record follows you into later past performance evaluations.
- Fines. Violations are subject to the penalties in 15 U.S.C. 645(d), with the fine treated as the greater of $500,000 or the dollar amount spent on subcontractors in excess of the permitted level.
- Debarment. Failing to honor the spirit and intent of a subcontract with a similarly situated entity may be a basis for debarment.
The regulation lists circumstances that can justify a satisfactory rating despite a miss, such as government-directed scope changes, unforeseen labor shortages and good-faith reliance on a subcontractor’s representation of its size or status.
What this means for a software company
- Decide who performs before you bid. If an implementation partner or integrator will do most of the services work, a set-aside prime role may not fit. A teaming or subcontracting arrangement where the partner primes can be the cleaner structure.
- Know your status and your partners’. Similarly situated status is what lets a partner’s work count as yours. Confirm each subcontractor’s status at award and watch for changes, because the prime can no longer count a subcontractor that stops qualifying.
- Separate cloud costs in your pricing. If hosting is not the principal purpose of the acquisition, keeping cloud costs visible as other direct costs supports the exclusion in paragraph (a)(1).
- Track it as you invoice. Compliance is measured over a contract period or an order. Keep a running record of the value of work performed by you, by similarly situated subcontractors and by everyone else.
- Keep evidence ready. Invoices and subcontracts are what a contracting officer will ask for.
Where this fits
The limitations on subcontracting are the price of the set-aside preference. They do not stop a software company from using partners, but they decide how much of the work those partners can do when you are the small business prime.
Score your company’s federal readiness to see how your registration and small business profile look next to the other categories federal buyers review.
Related reading
The CMMC brief
What the Phase 2 suspension changed and what it did not — the obligations that still bind, the assessment path a contract puts you on, the scoping decision that drives the cost, and the sequence that fits inside a pipeline. Sourced from the primary record.