Inside the Sequester: “Everything’s Ground to a Halt”

While some are sanguine about the economic impact of the sequester, one midsize government contractor is already feeling the blow.
David RosenbaumMarch 7, 2013

Since last Friday, when President Obama signed the order mandating $85.4 billion in immediate across-the-board spending cuts (the famous sequester), with almost half that amount hitting the Department of Defense budget, the Dow has hit an all-time high. A survey released today by the American Institute of CPAs (AICPA) reports that in the first quarter of 2013, 50% of its responding members were optimistic about their own business’s prospects, up from 41% in the last quarter of 2012.  Also today, the National Federation of Independent Business said 81% of its responding members believe “spending cuts should take priority over tax increases to reduce the deficit.”

It seems some people are happy (or at least sanguine) about the sequester.

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But that group doesn’t include Glenn Williamson, chief executive officer of KinetX, a 20-year-old, $125 million systems-engineering firm that specializes in space systems, wireless communications, and embedded computing. Williamson is not the least bit happy.

“We’ve already lost work,” he says. The prime Defense Dept. contractors KinetX supplies companies such as Lockheed Martin, Boeing, and Raytheon (one, two, and three, respectively, in terms of their 2012 Defense Dept. revenue), among others  already are feeling the impact of the cutbacks. And the impact rolls downhill to companies like KinetX.  These prime contractors have “cut back job tasks. They’ve said we don’t need your people, or we’d like to cut back rates [on KinetX contracts]. So now we’re paying more to our people than we’re getting paid for them,” says Williamson.

“Or they’re saying to us, ‘If you want to be on our best-vendor list, you have to agree to 75 days payable.’ So first they’re negotiating our rates down, and then they want us to wait 75 days to get paid,” he adds.

Plus, because of the uncertainty introduced by the sequester, contract officers at the prime contractors are not making decisions. “No contract officer wants to put his name on anything,” Williamson says.

And it gets worse. Not only is KinetX a subcontractor for big DoD suppliers, about two years ago it decided to try to become a prime contractor itself. That was after the American Recovery and Reinvestment Act of 2009 began funneling billions into government contracts. It was also a period when the Small Business Jobs Act of 2010 began emphasizing federal contracting opportunities for small business. (In 200920011, more than $211 billion in federal contracts were awarded to small business, according to the Small Business Assn.) KinetX, like many smaller businesses, wanted a piece of that action.

In his blue moments, that’s a decision Williamson says he now questions.

The Reality of Government Work
Williamson, a former investment banker, says that to become a prime Defense Dept. contractor KinetX first had to be Defense Contract Audit Agencycompliant. That meant not only do you have to have commercial auditors, you also have to have the government come in to verify that you’re worthy of being able to do government work. 

That means installing government accounting, says Williamson, who says he spent about half a million dollars to put in a new accounting system and another half million to become DCAAcompliant. And, he adds, “that’s all before you’ve won anything. That’s just to be able to sit down at the table.”

Williamson and Susan Dater, the company’s CFO, ramped up KinetX’s accounting system so it could break down every employee’s hourly rate, “dividing the dollar 14 different ways” to “make sure there’s no overhead put in the contract that makes it look like we’re trying to take advantage of the government,” he says.

He says he now grasps why prime contractors are so bureaucratic. “I’ve run lots of companies, and financed lots of companies, but being a Defense Dept. contractor involves the most challenging financial work I’ve ever had to do. This taxes every ounce of my knowledge base just to figure out how it all works. To get to that level of detail, the pain and angst of the financial structure, it’s mind-numbing,” he says. 

Williamson says it took a year to get KinetX’s accounting ready to bid for government contracts, and doing so almost “bankrupted the company.” And now that its accounting capability is “all ramped up,” now that there are “50 engineers sitting in the back of the facility ready to go,” sequestration has arrived and everything has ground to a halt. Meanwhile, KinetX is paying for its new systems, its added accounting staff, as well as the engineering team, paying salaries and benefits. Now, he says, he’s “biting a multimillion-dollar bullet.”

Life under the Sequester
Williamson may be biting that bullet for a while. According to Brett Johnson, a partner specializing in negotiating government contracts and compliance at Snell & Wilmer, a 400-attorney business-law firm, the sequester cuts are “a done deal.” 

Government agencies, including Defense, have “taken a hard look at programs and projects and realized that there are good opportunities to get rid of some nonessential stuff, even if the Congress and the President come to terms on a better plan for cuts. The bureaucrats have been planning for sequestration,” analyzing projects and contracts that could be eliminated or decreased, and now they’re implementing those cuts. “There won’t be a rewind,” Johnson predicts.

KinetX also planned for the sequester. “If you don’t have capital set aside, your problems become apparent from the moment you receive notice that a contract has been cancelled. There’s a profound impact on cash flow,” Williamson says.

Accordingly, the whole company took a 10% pay cut a year ago, and “the entire management team took a 50% cut four months ago,” says Williamson. “That’s how we manage cash. And we’re not accruing. No one’s going to take a big bonus. This is how we’re keeping this baby alive. Every day is a gift to buy time for the business-development team.”

Along with managing cash flow “every single day,” KinetX anticipated the pain of the sequester by building up its business-development team to go after commercial and international work. But doing business abroad has its own challenges for a Defense Dept. contractor.

“You’re a DoD subcontractor and you want to work with France?” Williamson asks rhetorically. “Now you’ve got more trouble. Because we make stuff for the U.S. military, we fall under State Department International Traffic in Arms regulations, which require segregating lots of accounting: what you can and cannot show. You also fall under Foreign Ownership, Control or Influence [FOCI],” he says. 

“Say I want to borrow $10 million, and only the Bank of Canada will lend it to me. I can’t because I’m a subcontractor to the military and the government doesn’t want foreign interests in the military supply chain,” he adds. For Williamson and Dater, that means money available outside the United States is not available to KinetX.

With all the challenges that come with life under the sequester, Snell & Wilmer’s Johnson strongly advises small and midsize businesses with government contracts not to put their head in the sand. “Second- and third-tier contractors serving prime contractors think [the sequester] is not their problem; it’s going to be the other guy. That’s not the case,” he says.

Johnson is telling his small-business clients to have candid conversations with their contracting partners to find out if their head is “on the chopping block.” He says that for smaller businesses, it’s time to “batten down the hatches” and make sure they are properly documenting transactions and the state of their projects.

“If you have goods in the pipeline,” Johnson says, a company is entitled to full compensation from the government, even if the project has been cancelled. “If you have to put people in idle, that’s possibly a claim against the government,” he says.  

But in order to make your claim, your accounting system must be “properly tracking the shift between the direct costs you’ve incurred on a contract and the indirect costs. You receive a stop-work order, that employee working on it is shifted into overhead and is now an indirect cost to the contract. Companies that fail to properly account for that shift may miss out on possible compensation in cases of termination-for-convenience (which government contracts allow). It’s the same with idle equipment,” says Johnson. 

Williamson is not thinking about recouping money on the contracts KinetX has out. He’s managing cash flow. “All senior managers  not just the CFO and myself  go through painstaking financial meetings; if one of us is going on a trip, we get to question why,” he adds.

He’s also thinking about the upside of the sequester’s downside. KinetX, he says, has no debt, and no outside investors. Every employee owns shares in the company, and it’s profitable “every month, quarter, and year. We’ve had to lay a couple of people off, yes, and that’s painful. But far fewer than almost everybody else.” 

“An unsung benefit to our company will be watching our competitors go out of business,” Williamson adds, grimly. “I just wish I had had another six months [before the sequester] to plan.”

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