(FORTUNE Small Business) -- The Small Business Administration and preferential contracting - procurement policies designed to assist small companies and other vendors designated as disadvantaged in open competition - have been inexorably linked for more than 50 years.

Back in 1953, when Congress established the SBA with passage of the Small Business Act, legislators aimed to drive more government contracts to small companies. The current Congressional target calls for 23% of all federal procurement contracts to go to small firms, an increase from 1997's 20% goal.

One tool Congress authorized to help make this happen? Set aside programs for small businesses, which were created by a 1977 law. These programs allow government agencies to limit competition for certain contracts to small-business bids only.

"Set asides are like boxing, where you have a middleweight and a heavyweight class," said Lloyd Chapman, president of the American Small Business League (ASBL), a lobbying group. "Congress knew the average small business couldn't compete head-to-head with General Motors."

As a whole, the federal government has done well in hitting its small-business targets: It has reached or come close to the 23% threshold every year since 1999, according to Fay Ott, the SBA's associate administrator for government contracts. Of the $340 billion in government contracts that went out in 2006, $77.6 billion went to small businesses, she said.

Where government agencies fall short is in meeting goals for small-business subcategories earmarked for special assistance. Businesses owned by service-disabled veterans are targeted to receive 3% of government contracting dollars, but landed less than 1% in 2006, according to an SBA scorecard.

Contract awards to small businesses owned by women, targeted for 5% of government spending, and those located in economically challenged "HUBZones," earmarked for 3%, also fell short of their 2006 targets.

But behind the numbers, how well set-asides work at achieving diversification goals remains a controversial and challenging question - as illustrated in the recent uproar over the SBA's proposal to limit a set-aside program for woman-owned businesses to just four industries.

Loopholes and abuses

The Federal Acquisition Regulation, the set of rules governing the contracting process for goods and services, mandates that contracts valued at less than $100,000 be automatically earmarked for small-business fulfillment, and that larger contracts be set aside if there's a "reasonable expectation" that at least two suitable small businesses will bid. Within that framework lies ample room for loopholes.

In the last five years, a number of federal investigations and private studies have found significant abuse of the set-aside program, said the ASBL's Chapman. Indeed, a 2004 Center for Public Integrity report titled "Outsourcing the Pentagon" found that Titan Corp., a San Diego-based defense electronics firm with 12,000 employees and $2 billion in annual revenue that year, had won nearly $550 million in contracts under the small-business classification.

Studying the 2001 fiscal year, a U.S. Government Accountability Office report concluded that $460 million in government contracts won by five large companies were recorded as small-business awards.

One problem: Federal regulations allowed companies to be classified as "small businesses" over the life of a contract even if the business grew or was acquired. Because major vendors like Boeing (BA, Fortune 500) and Raytheon (RTN, Fortune 500) routinely gobble up smaller contractors, dollars recorded as flowing to small companies can end up in the coffers of giants.

To address the issue, the SBA changed its rules last year to require small businesses who have won contracts of five years or longer to recertify every five years, or within 30 days of an acquisition. A bill proposed by Sen. John Kerry, who heads the U.S. Senate Committee on Small Business and Entrepreneurship, would require businesses to be recertified every year.

Still, other potholes abound. Contracts awarded for work overseas are excluded from requirements to be considered for set asides, according to one Congressional staffer who studies the issue.

"That's a problem, particularly since a lot of money started going overseas after we went to war," said the staffer, who is not allowed to speak to the press for attribution.

Other business owners say antiquated government practices let corporations steal away what should be a protected small-business domain. Hazmat and tactical supplies contractor Daphne Krick noted that the Department of Defense's largest supply source - the U.S. General Services Administration Schedules program - is excluded from any set-aside considerations.

GSA Schedules establish long-term contracts with commercial firms, which can then directly supply government agencies with products and services at "most-favored customer" prices. Large businesses use those contracts to sell billions of dollars worth of goods in small deals of less than $100,000 - the threshold that would otherwise require the contract to be routed to a small vendor, said Krick, of the Fayetteville, N.C.-based DK Enterprises.

That's no small crack, said Krick, given that the center of gravity for federal government contracting is the Department of Defense, which accounts for 70% of all procurements.

Defense on center stage

"The Department of Defense is really the 900-lb. gorilla," said Mike Stamler, the SBA's press director. "It's responsible for so much federal contracting that if the DOD meets its goal, the federal government meets its goal. If it falls short, the federal government falls short."

Aware of its center-stage role, the DOD has hundreds of staffers devoted to earmarking opportunities for small businesses, according to Anthony Martoccia, the DOD's director of small business programs. Government regulations aside, the DOD sees advantages in seeking out smaller providers: "They don't have all the overhead layers these large companies do," Martoccia said. "You can call the president up if you have a problem."

For some government contractors, the system works smoothly. Lani Hay, a former naval intelligence officer and founder of the professional services company Lanmark Technology of Fairfax, Va., said set-aside programs were vital to her firm's growth in the early years.

"It was initially the only value proposition we had to leverage as an unknown new business startup," Hay said. By using that "initial foot in the door," Lanmark was able to build its name and reputation in the industry, she said.

Government contractor C.Y. Huang also acknowledged that set asides jump-started his fledgling company's growth in a crowded market.

Soon after he launched the logistical support services firm GSI out of Alexandria, Va. in 1999, Huang applied for the federal certification to classify his company as "small and disadvantaged" (which covers firms owned by a minority with an individual net worth of less than $250,000), allowing it to pursue a special subcategory of set-aside contracts.

Huang's first deal, a $5.8 million logistical-support project for the Army, kicked off GSI's climb. In the company's early years, 100% of its revenue came from contracts won through set-aside programs.

Many businesses that could qualify for set-asides don't chase after them. Of the estimated 6 million U.S. small businesses big enough to have employees (a figure that excludes around 20 million sole proprietorships), only 400,000 have registered for the SBA's small-business database.

Additionally, of the billions of dollars in contracts that the federal government awarded to small companies in 2006, only 22% were procured through set-asides, according to the SBA. The majority were won in open competition.

Certifying to compete for contracts

For companies that do wish to bid on earmarked contracts, the first step is to register with the government's Central Contractor Registration database. What qualifies as a "small" business varies by industry. For example, a manufacturing company with up to 500 employees qualifies, while the limit for a wholesaler would be 100 employees. Revenue thresholds also apply: General construction firms qualify with annual sales of up to $31 million, while travel agencies max out at $3.5 million.

Once registered, potential contractors can canvass for government contracts on the Federal Business Opportunities website, along with most agencies' websites. Certain industries, including information technology, construction and manufacturing, are more likely to see opportunities for set asides, according to the SBA.

"It shifts a little bit from year to year, depending on what the federal government needs," said Calvin Jenkins of SBA's government contracting office.

Companies that step up to fulfill those needs can reap handsome rewards. Nearly a decade after GSI's first deal, the company now employes 570 workers and earns less than 15% its revenue from set-asides. The rest of its sales come in open competition and through private-sector contracts.

Government set asides helped GSI get started - "but in the end you can't depend on them," Huang said. "You have to rely on your own resources."  

Source:  http://money.cnn.com/2008/03/14/smbusiness/sba_set_asides.fsb/index.htm?source=aol_quote