On April 3, 2020, the Small Business Administration (SBA) released additional guidance regarding the determination of “affiliate” status for purposes of eligibility for the Paycheck Protection Program (PPP), one of the programs enacted as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act on March 27, 2020. Unfortunately, this additional guidance did little to solve the eligibility dilemmas of venture-backed companies. 

Affiliate Determinations under SBA Framework for Paycheck Protection Program Loans

Overview

The SBA is a federal agency that provides support to entrepreneurs and small businesses in a variety of ways, including by making government-backed guarantees on loans from partnering lenders (known as 7(a) loans), and directly lending to small businesses that suffer economic harm after a disaster (known as Economic Injury Disaster Loans (EIDLs) or 7(b) loans).

With the agency’s focus on providing capital to those who cannot otherwise access it, most venture-backed companies do not typically qualify or seek to qualify for these programs. As a result, the SBA has, unsurprisingly, historically developed eligibility rules and definitions surrounding “Affiliates” without regard for standard control provisions often implemented by VCs or other sophisticated investors in connection with equity financings.

While the CARES Act reduces many typical SBA application requirements in an effort to ensure as many companies that need funds will be eligible to receive them, it does not address the subject of Affiliation outside of certain industries. This void has, in effect, created doubts as to whether some venture-backed companies will qualify for these programs, and led to raucous requests for clarification from the NVCA as well as Congressional leadership of both parties. 

With venture-backed companies suffering similar economic hardships as other small businesses and struggling to maintain payroll, the SBA has now released guidance on the Affiliation rules, providing that the standard SBA rules still apply. Therefore, companies will need to scrutinize their governing documents carefully for minority control provisions to determine “Affiliate” status.

Clarifications and Additional Guidance

What is an “Affiliate,” and why do they matter?

Affiliates exist when one business controls, is controlled by, or shares common control with, another business. For purposes of eligibility under SBA loan programs, the total number of employees of all Affiliates must be aggregated. Companies with over 500 employees (including Affiliates) cannot participate in the Paycheck Protection Program or obtain an EIDL. For example, this means that even if Ace Tomato Company only has 25 employees, if an investor with “control” over Ace Tomato Company also “controls” other companies with an aggregate of over 475 employees, Ace Tomato Company would be ineligible for the loan programs since it would be deemed to have in excess of 500 employees due solely to application of the SBA’s Affiliate Rules.

How is “Control” defined?

The SBA has a broader definition of “control” than is typically understood in most businesses. “Control” for SBA purposes may be affirmative (directing the actions of the company) or negative (preventing the company from taking action). Negative control can be particularly problematic in the case of many venture-backed companies, as some relatively common investor rights and protective provisions can lead a minority investor (and therefore all the other companies they “control”) to be deemed an Affiliate.

What is Affirmative Control?

Affirmative Control is found in:

• Holders of over 50% of outstanding voting equity of the company;

• Holders of over 50% of equity of a company after giving present effect to all options, warrants, or convertible securities (unless subject to conditions precedent which are incapable of fulfillment, speculative, conjectural, or unenforceable, or where possibility of exercise is shown to be extremely remote);

• An Investor’s ability to designate, appoint or elect a majority of a Board of Directors or similar body; or

• The CEO, President, or other person controlling the management of a company.

What is Negative Control?

Negative Control may be found when a minority owner can unilaterally prevent a Company from:

• Making, declaring, or paying distributions or dividends other than tax distributions;

• Establishing a quorum at a meeting of stockholders (and likely, by extension, at a meeting of the board);

• Approving or making changes to a company’s budget or approving capital expenditures outside the budget;

• Determining employee compensation;

• Hiring and firing officers and executives;

• Blocking changes in the company’s strategic direction;

• Establishing or amending an incentive or employee stock ownership plan;

• Incurring or guaranteeing debts or obligations;

• Initiating or defending a lawsuit;

• Entering into contracts or joint ventures;

• Amending or terminating leases.

These negative controls, or “veto rights,” generally take the form of (i) requiring approval of a certain director appointed by the minority owner, (ii) requiring approval of a series of voting equity that the minority owner controls, or (iii) requiring approval of the minority owner directly.

Where should I look for these Negative Control provisions?

All of a company’s governing documents and investor agreements should be reviewed for these issues. Particular care should be given to the following documents (to the extent applicable):

• Certificate/Articles of Incorporation;

• Investors’ Rights Agreement;

• Stockholders’ Agreement;

• Management Rights Letters; and

• Operating Agreement (in the case of an LLC)

What about other definitions of Affiliation regarding minority holders I’ve seen, such as having a large amount of voting equity compared to other holders?

The SBA actually has different definitions of “Affiliate” for different purposes. The loan programs are governed by 13 CFR §121.301, which does not include some of the broader provisions regarding minority holders generally used by the SBA, which are set forth in 13 CFR §121.103. These inapplicable provisions include minority holders (individually or together with similarly situated minority holders) that hold a “large” amount of voting equity compared to others. The new guidance set forth by the SBA has re-affirmed that the more lenient Affiliate rules of 13 CFR §121.301 are applicable to the PPP.

Can we amend our corporate documents to address problematic control provisions?

There is no clear guidance on this issue from the SBA or Treasury Department. However, many companies are taking this approach. By amending organizational documents and agreements prior to the submission of a company’s loan application to remove the relevant controls, we believe companies are taking the best possible steps to ensure that they aren’t deemed to be Affiliates of any other portfolio companies of their investors. Any such amendments should be permanent and binding to ensure they are effective.

Can we simply ask potential Affiliates to temporarily waive any problematic controls while a loan is outstanding?

Again, there is no clear guidance on this action, but we would counsel against this approach. In previous economic downturns, companies taking temporary measures in an attempt to become eligible for government assistance have later come under fire for such actions.

Conclusion

Our entire Emerging Companies team, spread across offices spanning the country, is working to keep our clients informed about these and other important issues during this difficult time. While we had hoped for more direct guidance from the SBA and Treasury Department, we have had many productive conversations with impacted clients and will continue to distribute additional information in the coming days regarding these provisions.