Contract Novation in Mergers and Acquisitions

Key considerations for government contractors looking to sell

business owner who is preparing to sell their company should consider, among other things, the process by which the company’s contracts will be transferred to the buyer. If the company has contracts with the state or federal government, the transfer of those contracts may require going through the contract novation process. This article will discuss what a novation is, the circumstances in which novations are required, and several considerations related to contract novation that government contractors should think about when preparing to sell their business.

In general, a novation is the substitution of a new contract for an existing contract. A novation usually involves an agreement to substitute a third party for one of the existing parties to a contract. The novation replaces the original contract with a new contract in which the third party assumes the rights and obligations of the party it replaced.

In the government contracting context, a novation is an agreement between the government, the original contractor, and a new contractor, whereby the contract between the government and the original contractor is canceled and replaced with a contract between the government and the new contractor. The rights and obligations of the original contractor are effectively transferred to the new contractor.

A novation is often necessary when a company that has contracts with either the state or federal government is being sold to a buyer via an asset purchase. When a company is sold to a buyer, the company’s contracts are assets of the business and are typically included with the rest of the assets that the buyer is purchasing. A sale of the company would thus require the contracts to be assigned or otherwise transferred to the buyer.

Under Alaska law, a state contract or subcontract may not be transferred or assigned to a third party without the prior written consent of the state procurement officer responsible for the contract. If the procurement officer determines that it is in the best interest of the state, the state will recognize the third party as the successor in interest to the contract via a novation agreement in which the original contractor and the third party agree that, among other things, the third party will assume all of the original contractor’s obligations under the contract, and the original contractor will waive all of its rights against the state under the contract.

Federal law similarly prohibits the transfer or assignment of federal government contracts from the original contractor to a third party. The novation process is an exception to this prohibition. If the government determines that a novation is in its interest, it may recognize a third party as the successor in interest to a contract via a novation agreement. A novation is required when the third party acquires either all of the contractor’s assets or all of the contractor’s assets involved in performing the contract, but a novation is typically not required if the third party acquires the contractor via a stock purchase and there is no legal change in the contracting party.

For both state and federal government contracts, the novation process can be complex and time-consuming. Federal regulations prescribe a lengthy list of documents that the contractor must submit to the government in connection with the novation request, some of which may be burdensome to obtain. The state and federal governments have broad discretion in determining whether to grant a novation request, what documentation to require in support of the novation request, and how quickly the process moves. For federal contracts, the government’s approval of the novation will not occur until after all of the contractor’s assets have been transferred to the buyer, which creates a risk that the government might refuse to consent to the novation of a contract that is key to the contractor’s business after the acquisition has already closed. In light of the foregoing, there are several things that the parties should think about when considering transactions in which a buyer is acquiring a government contracting business.

First, the parties should consider whether the proposed transaction can be structured in a way that does not require novation. Novation will likely be required if the transaction is structured as an asset purchase, but there are other transaction structures, such as a stock purchase, which may not require contract novation.

If contract novation will be required in connection with the transaction, then the parties should start thinking about the novation process as early as possible. The contractor should identify the contracts which will require novation early in the deal process and should consider approaching their government customer as soon as practical to discuss the details and required documentation.

A contractor selling their business should also consider whether it would be beneficial to engage an expert to help navigate the government approval process. Contractors who need to go through the novation process, particularly at the federal level, may find it helpful to work with an attorney or other expert who has experience working on acquisitions that involve government contract novation.

Finally, the parties should consider whether the purchase agreement or other acquisition documents need to include any provisions related to the contract novation process. For example, in cases where the government will approve the novation post-closing, the parties may want to include a provision in the purchase agreement that requires the parties to cooperate with each other to obtain the novation after closing. The parties may also want to consider whether and how the acquisition documents should address what happens in the event the government’s approval is delayed or denied.

In sum, government contractors looking to sell their business should be aware of any potential contract novation requirements and should start planning early in the acquisition process.