The Government Contract Complication - How Federal and State Contracts Create Unique Exit Challenges

That $8 million federal contract powering your company’s growth—representing perhaps 40% of your total revenue—could become the very obstacle that prevents your exit. Government contracts, while prized for their stability and payment reliability, carry hidden transferability complications that catch business owners off guard when it’s time to sell.

Executive Summary

Government contracts represent some of the most stable revenue streams available to small and mid-sized businesses, particularly in defense and services sectors, though they remain subject to budget cycles and appropriations uncertainty. They also create some of the most complex exit scenarios we encounter in our advisory practice. Unlike commercial customer relationships that transfer relatively seamlessly during acquisitions, government contracts involve a web of regulatory requirements, approval processes, and qualification dependencies that can delay, complicate, or even derail business sales.

The core challenge stems from the government’s legitimate interest in controlling who performs its contracted work. Federal contracts generally require formal novation agreements for assignment to new owners in asset sales and mergers, though stock sales, where the buyer acquires ownership interests rather than assets, may not trigger novation requirements because the contracting entity itself remains unchanged. But stock sales do not eliminate security clearance review requirements or prevent set-aside qualification loss. Security clearances tied to key personnel require re-evaluation during ownership changes and may face suspension during the review period. Set-aside qualifications based on ownership demographics are typically lost when sold to buyers who don’t independently meet the qualifying criteria.

For business owners with significant government contract revenue, exit planning must begin years earlier than for comparable commercial-focused businesses. Understanding the specific transfer mechanics for your contract types, identifying which relationships carry the highest transfer risk, and proactively managing these complications can mean the difference between a successful exit and a failed transaction. Based on our experience with government contractor exits over the past decade, companies that begin addressing these challenges 18-36 months before their target exit date achieve meaningfully better outcomes than those who discover complications during due diligence. This timeline varies significantly based on contract complexity, buyer experience, and agency relationships.

This article examines the unique challenges government contracts typically create during business sales, provides frameworks for assessing and managing these risks, and outlines strategies for positioning government-heavy businesses for successful ownership transitions.

Introduction

In our advisory practice, we’ve encountered numerous business owners whose government contracts created unexpected exit complications, discovering at transaction time that their most valuable asset was far more difficult to transfer than they anticipated. The government contract complication represents a specialized variant of customer concentration risk, one that layers regulatory and legal complexity onto the already challenging dynamics of revenue dependency.

The appeal of government contracts is understandable. Federal, state, and municipal customers offer payment reliability that commercial customers rarely match. Contract terms often span multiple years, providing revenue visibility that supports planning and growth. Government spending in many sectors continues regardless of economic cycles, offering counter-cyclical stability. For businesses that successfully navigate the procurement process, government contracts can become cornerstone revenue sources.

But these benefits come with strings attached, strings that become most visible during ownership transitions. Government contracting exists within a regulatory framework designed to protect taxpayer interests, ensure fair competition, and maintain accountability. These protections translate into three specific requirements that directly impact transaction structure and timing: government approval of contract assignments through novation, review of security clearance eligibility under new ownership, and potential loss of set-aside qualifications if the buyer doesn’t independently qualify.

The government contract complication typically affects these primary areas during business transactions, though the severity varies significantly by contract type, buyer experience, and agency relationships. First, contract assignment typically requires government approval through novation, where the government agrees to recognize a new party to the contract, though this approval is discretionary, not automatic. Second, security clearances held by the company are subject to re-evaluation and potential suspension or revocation during ownership changes, even in stock transactions. Third, set-aside qualifications may be lost when the buyer doesn’t meet the original qualifying criteria, though certain transaction structures, such as management buyouts where qualifying individuals retain majority control, may preserve eligibility in limited circumstances.

Understanding these dynamics is required for any business owner whose revenue depends significantly on government customers. The time to address these complications is during your exit planning phase, not during transaction negotiations.

Understanding Government Contract Transfer Mechanics

The foundation of government contract transferability lies in a principle that surprises many business owners: government contracts are generally not assignable without government consent. Unlike commercial contracts where assignment clauses are negotiable between parties, government contracts exist within a statutory and regulatory framework that gives the government substantial control over who performs contracted work. Federal contracts are subject to novation requirements under FAR 42.1204, while state and municipal contracts operate under different procurement rules with varying assignment requirements. Each contract should be individually reviewed for its specific provisions.

The Novation Requirement

For federal contracts, the primary mechanism for transferring contract rights and obligations to a new owner is the novation agreement. A novation is a three-party agreement between the government, the original contractor, and the successor contractor where the government agrees to recognize the successor as the new party to the contract. While novation is generally permitted under FAR 42.1204, the contracting officer retains discretion to delay or deny approval based on the successor’s capability and risk profile. According to FAR 42.1204(a), the contracting officer must evaluate factors including the technical competency, responsibility, and financial capability of the successor entity before approving any novation. A buyer who appears less capable, more expensive to oversee, or carrying additional risk may face conditioned or denied approvals, a risk that ranges from approximately 5-15% for experienced government contractor buyers to 15-30% for buyers without government contracting experience, based on our transaction history.

The Federal Acquisition Regulation governs novation requirements for federal contracts. Under FAR 42.1204, novation is generally required when a contractor’s assets are transferred, when the contractor itself is sold, or when the contractor merges with or is consolidated with another entity. The contracting officer must determine that the novation is in the government’s interest before approving the agreement. This is not a rubber-stamp process.

The novation process typically requires extensive documentation, including the asset purchase or merger agreement, the new entity’s financial statements, evidence of the successor’s capability to perform the contract, and a detailed list of affected contracts. In our experience with government contractor transactions, processing times are highly variable, typically ranging from three to twelve months or longer depending on the complexity of the contracts involved, the contracting agency’s workload, and the completeness of the documentation provided. Defense-related contracts often face longer timelines than civilian agency contracts. Early engagement with the contracting officer is needed for realistic timeline planning.

State and municipal contracts operate under varying rules, but many follow similar principles requiring government consent for contract assignments. Business owners should review the specific assignment provisions in each government contract and understand the applicable regulatory framework governing transfers, as the rules vary significantly by jurisdiction and contract type.

Security Clearance Complications

Businesses holding facility security clearances face additional complexity during ownership transitions, complexity that persists even in stock sale transactions. Security clearances exist at two levels with different implications. Facility Clearances (FCL) are granted to the company itself and are subject to review and potential revocation if ownership changes create foreign ownership, control, or influence (FOCI) concerns. Individual security clearances are held by employees and may allow them to work for a new owner, but changes in key cleared personnel can create performance gaps.

When ownership changes, notification typically comes through the contractor’s Facility Security Officer (FSO) to the Defense Counterintelligence and Security Agency (DCSA). DCSA will evaluate whether the new ownership structure creates foreign ownership or control concerns. Even foreign ownership stakes below 25% can trigger review if the foreign owner has access to sensitive positions or information.

Facility clearances held by the company are subject to re-evaluation and potential suspension or revocation during ownership changes, regardless of whether the transaction is structured as an asset sale or stock sale. A transaction should not assume classified work revenue is secure until DCSA has completed its review and re-certified the facility clearance under new ownership. Based on industry practitioner reports and our experience, this review typically takes three to six months but may extend longer if the buyer presents additional complexity such as foreign ownership or changes in cleared personnel.

If the buyer involves foreign ownership, the FOCI implications can create significant transaction risk. Foreign ownership creates these concerns because the government needs assurance that U.S. national security interests are protected. A foreign owner with access to classified information or sensitive technical data represents a risk the government must evaluate. Depending on the foreign ownership stake and the buyer’s ability to implement mitigation measures, board resolutions, proxy agreements, or compartmentalization, the government may require extensive mitigation or deny continued clearance eligibility, requiring the business to terminate classified work.

Changes in key management personnel holding clearances create additional gaps. If cleared personnel depart during or after the transaction, the business may lose its ability to perform classified work until replacement personnel obtain clearances. Security clearance processing timelines vary significantly based on clearance level, agency, and background complexity. According to DCSA processing metrics and industry practitioner experience, Secret clearances generally take six to twelve months while Top Secret clearances often require twelve to eighteen months or longer. Current processing backlogs, which have fluctuated significantly in recent years, may extend these timelines further. Business owners should verify current processing estimates with their FSO before transaction planning.

Set-Aside Qualification Vulnerabilities

Perhaps the most significant government contract complication involves set-aside qualifications. Federal procurement includes programs designed to direct contract opportunities to specific categories of businesses: small businesses, women-owned small businesses (WOSB), service-disabled veteran-owned small businesses (SDVOSB), businesses in Historically Underutilized Business Zones (HUBZone), and disadvantaged small businesses participating in the 8(a) Business Development program, among others.

These set-aside qualifications are based on specific ownership and control requirements defined by SBA regulations. Set-aside qualifications are typically lost when the buyer doesn’t independently qualify for the same program. For example, an 8(a) business owned by a disadvantaged small business owner will lose its 8(a) status if sold to a buyer who is not independently eligible. Even if 10% of the original ownership structure is retained by the qualifying individual, that’s typically insufficient to maintain 8(a) status, which requires control, not just ownership. Some transaction structures, such as management buyouts where qualifying individuals retain majority control, may preserve qualification eligibility in limited circumstances. This requires careful legal structuring and should be reviewed with government contracts counsel.

This creates a fundamental tension in the transaction. The buyer is often purchasing the business precisely because of its government contract revenue, but the very contracts driving that revenue may not survive the ownership transition without successful recompetition. To illustrate the calculation methodology: a business deriving 60% of its $8 million revenue from 8(a) contracts ($4.8 million annually) faces a significant valuation challenge. Assuming a revenue multiple of 0.8x and complete loss of set-aside eligibility with a 40% probability of winning recompetition under open terms, the expected valuation impact would be calculated as follows: $4.8M × 0.8x = $3.84M gross impact × 60% probability of loss = approximately $2.3M in expected value reduction. The buyer must either discount that revenue stream significantly, identify a transaction structure that preserves qualification, or accept that the revenue requires recompetition under open terms, with success rates typically ranging from 30-60% depending on competitive position.

In one case we observed, a $12 million business with 70% of revenue from IDIQ contracts initiated an exit with a financial buyer unfamiliar with government contracting. The novation process for three primary contracts took eight months, longer than the initial four-month estimate due to incomplete accounting system certification. Two of three contracts survived transfer; one was recompeted and lost to a competitor. The buyer revised valuation downward by 15% based on the extended timeline and reduced revenue certainty. This example illustrates how complications compound when not addressed proactively. We should note that many government contract transfers do proceed smoothly when properly planned, particularly with experienced buyers and straightforward contract structures. This case represents challenges that commonly arise with inexperienced buyers and complex portfolios.

Assessing Your Government Contract Portfolio Risk

Not all government contracts carry equal transferability risk. A systematic assessment of your contract portfolio helps identify where complications are likely to arise and which relationships require the most attention during exit planning. Simple firm-fixed-price contracts with experienced government contractor buyers may require minimal additional planning, while complex portfolios with security clearances and set-aside qualifications demand extensive preparation.

Contract Type Analysis

Different contract types carry different transfer implications. Firm fixed-price contracts typically present lower transfer risk than cost-reimbursement contracts, which involve more intensive government oversight of contractor operations and require accounting systems meeting specific government standards. Indefinite Delivery/Indefinite Quantity (IDIQ) contracts may have task orders at various stages that complicate the transfer timeline. Contracts in their option years may be approaching recompetition regardless of ownership changes.

Revenue Concentration Mapping

Understanding how government contract revenue is distributed across your portfolio reveals where transfer complications would have the greatest impact. We recommend mapping each government contract against several risk factors:

Concentration percentage: What portion of total revenue does each contract represent? In our experience, contracts representing 10-20% or more of revenue typically warrant detailed transfer planning because complications with these contracts materially affect overall transaction value.

Transfer mechanism required: Does the contract require novation, simple notification, or another consent process? What is the realistic timeline for that process with the relevant contracting agency? Federal defense agencies often process more slowly than civilian agencies.

Qualification basis: Was the contract awarded under a set-aside program, and will that qualification survive the anticipated transaction structure? If the buyer doesn’t independently qualify, evaluate whether the contract can be won under open recompetition. Success rates typically range from 30-60% depending on your competitive position, incumbent advantage, and pricing flexibility.

Clearance dependency: Does contract performance require facility clearances or individual clearances that may be affected by ownership changes? What is the FOCI risk profile of likely buyers? Remember that security clearance reviews occur even in stock transactions.

Relationship strength: How strong are relationships with the contracting officer and program office? Strong relationships can support the approval process, though contracting officer rotation (typically every 18-36 months) and regulatory constraints limit the impact of personal relationships. Focus on demonstrating consistent performance and compliance.

Contract timeline: Where is each contract in its lifecycle? Contracts approaching recompetition may naturally transition regardless of ownership, while contracts with multiple remaining option years represent longer-term transfer challenges but also greater value at risk.

Identifying Critical Dependencies

Beyond the contracts themselves, government contract performance often depends on specific personnel, systems, or certifications that may not automatically transfer during a transaction.

Key personnel requirements in government contracts may specify individuals by name or require government approval for changes. If those individuals plan to depart after the transaction, the contract terms may require government notification and approval of replacements, a process that adds timeline uncertainty.

Accounting systems approved for government contracting must be maintained or transitioned carefully. Cost-reimbursement contracts require accounting systems meeting Defense Contract Audit Agency (DCAA) standards. Changes to these systems during ownership transition require attention, and buyers without existing DCAA-compliant systems face significant implementation costs and timelines.

Certifications such as ISO standards, CMMI ratings, or industry-specific credentials may be tied to the current corporate entity. Understanding which certifications transfer and which require recertification helps avoid surprises during the transaction and provides realistic timeline expectations.

Strategies for Managing Government Contract Transfer Risk

Business owners cannot eliminate government contract transfer complications, but proactive planning can significantly reduce their impact on transaction outcomes. Business owners might accept reduced valuations to accelerate timelines, or divest government contracts before sale to simplify transfers. Early planning is generally superior when the value of preserved contracts exceeds the cost of extended preparation.

Early Engagement with Contracting Officers

Building relationships with contracting officers before any transaction is contemplated can support faster novation approvals and more favorable agency attitudes toward ownership transitions. But contracting officer rotation (typically every 18-36 months) and regulatory constraints limit the impact of personal relationships. Focus on demonstrating consistent performance and compliance rather than relying on individual relationships that may not persist through your transaction timeline.

Maintain regular touchpoints with contracting officers through quarterly performance reviews, proactive disclosure of any changes in key personnel or ownership structure, and inclusion in relevant project milestones. This establishes a track record of transparency and reliability that supports the contracting officer’s comfort level when exercising discretion during novation reviews.

Structural Alternatives to Novation

In some situations, transaction structures can minimize or avoid novation requirements. Stock sales, where the buyer acquires the ownership interests of the existing corporate entity rather than its assets, may not trigger novation requirements because the contracting entity itself remains unchanged, only its ownership changes.

But stock sales have their own complications that business owners frequently underestimate. Buyers often prefer asset purchases for liability protection and tax benefits. Security clearance notifications and DCSA review are still required even in stock transactions. The clearance review process does not disappear simply because the legal entity remains unchanged. Set-aside qualifications may still be lost depending on the new ownership structure and whether qualifying individuals retain required control.

In some cases, attempting to preserve set-aside contracts through transaction structuring may be less feasible than accepting that these contracts will be lost and focusing transfer efforts on contracts without set-aside restrictions. This is particularly true when the buyer cannot independently qualify for the set-aside program. Business owners should evaluate whether the cost, time, and uncertainty of managing multiple novations is worthwhile versus accepting contract loss and adjusting valuation expectations accordingly.

Consulting with both transaction counsel and government contracts counsel early in the planning process is required. Government contracts specialists are necessary because general transaction attorneys often lack expertise in novation mechanics, set-aside program rules, and security clearance implications. Plan for three to six months of parallel legal review with both counsel types.

Diversification Before Exit

For businesses with high government contract concentration, particularly those dependent on set-aside programs, diversifying revenue before exit may be necessary for transaction success. Adding commercial customers or government contracts that don’t depend on set-aside qualifications creates transferable revenue that supports valuation regardless of what happens to set-aside contracts.

Revenue diversification timelines are highly variable, but companies planning significant portfolio shifts should begin three to five years before their intended exit date to allow time for meaningful progress. In our experience, companies building meaningful commercial customer revenue streams while maintaining government contracts typically require this timeframe to shift 20-30% of revenue. This timeline depends heavily on market conditions, sales team capability, and product-market fit in commercial markets.

Buyer Selection and Qualification

Not all buyers face the same government contract transfer challenges. Strategic buyers who already hold government contracts may have established relationships with contracting agencies, existing security clearances, and familiarity with novation processes. Some buyers may independently qualify for the same set-aside programs, allowing contracts to continue under new ownership without qualification loss.

Understanding your government contract transfer requirements helps identify which buyer categories represent the best fit. A buyer already performing similar work for the same agency may face minimal transfer friction, potentially reducing novation timelines to three to four months versus eight to twelve months for an unfamiliar buyer. Financial buyers with no government contracting experience face substantially greater hurdles and should expect longer timelines, higher transaction costs, and greater revenue uncertainty.

Depending on the contract terms and recompetition process, a new owner who doesn’t qualify for set-asides may still be able to win the same work under different terms or in open competition. The key is to evaluate each set-aside contract’s recompetition risk separately rather than assume all such revenue is forfeit.

Full Cost Accounting for Government Contract Transactions

Business owners frequently underestimate the true cost of government contract complications during transactions. A complete cost picture includes direct expenses, indirect costs, and opportunity costs.

Direct costs typically include:

• Specialized government contracts counsel: $15,000-$50,000 or more depending on portfolio complexity
• Extended transaction timeline legal and advisory fees: $25,000-$75,000 additional
• DCSA security reviews and compliance support: $10,000-$30,000
• Accounting system documentation and compliance verification: $15,000-$50,000

Indirect costs frequently overlooked:

• Executive and owner time investment: 200-500 hours × opportunity cost
• Internal team distraction during extended transaction process
• Potential business disruption affecting contract performance

Opportunity costs that affect total value:

• Market timing risk from extended timelines (6-18 months longer than commercial transactions)
• Deal value erosion during prolonged negotiations
• Risk of failed novations: 5-30% probability depending on buyer experience × contract value at risk

When we account for all cost categories, the total investment for managing government contract complications in a transaction typically ranges from $100,000 to $300,000 or more for moderately complex portfolios, plus significant opportunity costs that can equal or exceed direct expenses. Simple firm-fixed-price contracts with experienced buyers may require substantially less investment, while complex portfolios with security clearances and multiple set-asides may exceed these ranges.

Failure Modes and Risk Mitigation

Understanding how government contract transactions can fail helps business owners plan appropriate mitigation strategies.

Novation denial or excessive conditions: Contracting officers may deny novation or impose conditions that make the transaction uneconomic. This risk ranges from 5-15% with experienced government contractor buyers to 15-30% with inexperienced buyers. Mitigation includes buyer qualification assessment, early contracting officer engagement, and contingency planning for contract loss.

Extended timeline causing deal fatigue: Complex contract portfolios requiring multiple agency coordination, FOCI review, or extensive documentation can extend timelines beyond buyer or seller patience. This affects 30-50% of complex transactions in our experience. Mitigation includes realistic timeline planning from the outset, buyer education about expected duration, and interim revenue protection measures.

Set-aside recompetition failure: When set-aside qualifications are lost, the business must compete for the same work under open terms, typically facing 40-70% probability of losing to competitors who may offer lower prices or different capabilities. Mitigation includes commercial diversification before exit, competitive positioning assessment, and realistic valuation expectations.

Security clearance complications: Even in stock transactions, DCSA review may result in clearance suspension, revocation, or extensive mitigation requirements that affect classified work revenue. Mitigation includes early FOCI assessment, buyer selection that minimizes clearance risk, and contingency plans for clearance gaps.

Actionable Takeaways

Business owners with significant government contract revenue should take specific steps to address transfer complications well before initiating any exit process.

Conduct a comprehensive contract inventory that documents each government contract’s transfer requirements, set-aside basis, clearance dependencies, and key personnel requirements. This inventory becomes required due diligence documentation and helps identify where proactive attention is needed. Include the contracting officer’s name, contract expiration dates, option periods remaining, and any known agency attitudes toward novations.

Engage government contracts counsel to review your contract portfolio and advise on transfer mechanics. General transaction attorneys may not fully understand government contracting regulations, and specialized expertise is warranted for complex portfolios involving security clearances or set-aside qualifications. Budget $15,000-$50,000 or more for legal fees depending on portfolio complexity, plus $75,000-$200,000 for extended timeline and indirect costs. Begin this engagement 18-36 months before your target exit, longer for complex situations involving FOCI or extensive set-aside qualifications.

Build and maintain relationships through consistent performance and compliance documentation rather than relying solely on personal connections with contracting officers who may rotate before your transaction. Quarterly performance reviews, proactive disclosure of business changes, and reliable contract performance establish credibility that supports transfer approvals.

Assess your set-aside vulnerability with clear financial analysis showing your assumptions. Calculate: at-risk revenue × revenue multiple × probability of recompetition loss. If a substantial portion of your revenue depends on qualifications that will disappear upon sale and no qualifying buyer is identified, factor this into your exit timeline and valuation expectations.

Evaluate transaction structures that may reduce transfer complications. Stock sales, management buyouts, or sales to buyers who independently qualify for relevant set-asides may offer advantages over traditional asset sales to commercial buyers. But remember that stock sales do not eliminate security clearance reviews or automatically preserve set-aside qualifications. Each structure carries trade-offs that require analysis with both transaction and government contracts counsel.

Build realistic timelines. Government contract transfer complications typically add six to eighteen months to transaction timelines. If you initially planned a nine-month exit process, plan for fifteen to twenty-seven months when government contracts represent significant revenue. This extended timeline affects financing, buyer patience, and your own planning.

Conclusion

Government contracts represent a unique form of customer concentration that creates specialized exit challenges. The stability and reliability that make government customers attractive during operations become sources of complexity and risk during ownership transitions. Novation requirements with discretionary approval, security clearance re-evaluation and potential suspension, and set-aside qualification vulnerabilities each add layers of friction that can delay transactions, reduce valuations, or cause deals to fail entirely.

The government contract complication doesn’t make businesses unsellable, and many transactions involving government contracts proceed smoothly when properly planned, particularly with experienced buyers and straightforward contract structures. But transactions involving complex portfolios face higher complexity and longer timelines than typical commercial exits. Success depends on early planning, realistic timeline expectations, complete cost accounting, and experienced advisors who understand both transactional law and government contracting regulations. Business owners who wait to address these issues until due diligence often face reduced valuations or deal collapse.

Business owners who understand their government contract transfer landscape, build track records that support smooth transitions, and address structural vulnerabilities proactively position themselves for successful exits. Those who discover these complications only during transaction due diligence often face difficult choices: accept reduced valuations, restructure transactions under time pressure, or watch deals collapse entirely.

If government contracts represent a significant portion of your revenue, your exit planning should begin with a clear assessment of what you’re actually selling and what it takes to transfer those relationships to a new owner. The government contract complication is manageable, but only if you start managing it early enough and with realistic expectations about the time, cost, and uncertainty involved.