The SBA Paycheck Protection Program (PPP) was enacted to provide loans to small businesses to protect and maintain jobs. For those small businesses backed by venture capital or private equity, however, the affiliation rules make it much harder, if not impossible, to obtain the benefits of this program without eliminating previously negotiated investor protections.

To obtain the benefits of the PPP, a company must have not more than 500 employees or such greater number for the applicable industry in the North American Industry Classification System (NAICS). Included in this calculation are the number of employees of controlled portfolio companies of venture capital or private equity funds if the applicable investor is deemed to be affiliated with the subject company. The SBA’s definition of “affiliation” is much broader than the typical definition of that term because, under the SBA’s definition, affiliates include a venture capital or private equity fund that has blocking rights over certain “day-to-day” actions. If such an investor has blocking rights on “extraordinary” actions (such as amending a company’s certificate of incorporation or bylaws, issuing additional shares of capital stock, or entering into a substantially different line of business), such blocking rights, by themselves, will not create an affiliation between the investor and the subject company. For purposes of determining whether a venture capital or private equity fund has a blocking right, the analysis depends on whether the approval of the investor is necessary for the company to take the action. For example, if the approval threshold in the stockholder protective provisions is 80 percent of the series of preferred stock and a venture capital investor owns 30 percent of such series, then, depending on the stockholder protective provisions, such venture capital fund could be deemed an affiliate of the subject company under the SBA rules.

To obtain the benefits of the PPP, a venture capital or private equity-backed company will need to examine its certificate of incorporation, bylaws, and other governing documents to determine whether an investor has blocking rights over day-to-day actions. While not exhaustive, below are some examples of provisions that will (or may) create affiliation under the SBA rules.

• Provisions requiring an investor (or its director designee) to be present at meetings of a company’s board of directors or stockholders for purposes of determining whether a quorum is present.
• Provisions giving an investor blocking rights over day-to-day actions (such as protective provisions in a company’s certificate of incorporation). The following have been determined to be day-to-day actions (most of which are standard protective provisions in deals that adhere to national venture capital association guidelines): (i) the payment of dividends/distributions, (ii) determining employee compensation, (iii) the hiring and firing of executive officers, (iv) establishing or amending incentive/employee stock ownership plans, (v) purchasing equipment, (vi) changing a company’s strategic direction (other than entering into a substantially different line of business), (vii) amending or terminating existing lease agreements, (viii) incurring debt, (ix) approving the budget or changes thereto, (x) bringing or defending a lawsuit, or (xi) encumbering or selling assets (short of all or substantially all assets).
• Provisions that the director designee of an investor must approve day-to-day actions.
• Provisions granting an investor approval rights over day-to-day actions, such as altering a company’s budget.

If the venture capital or private equity fund has blocking rights over day-to-day activities, then the company must determine whether it (when combined with the other controlled portfolio companies of such venture capital or private equity fund) has more than 500 employees or such number for the applicable industry in the NAICS. If the company (when combined with such other controlled portfolio companies) has more than 500 employees or such number for the applicable industry in the NAICS, then the company and the investors will have to modify any such provisions in the company’s organizational documents if access to the PPP benefits is desired.

In recent guidance, the Treasury Department has stated that if an investor irrevocably waives or relinquishes any existing rights which would trigger affiliation with a company, such investor would no longer be affiliated with the subject company. We interpret this guidance to mean that the elimination of these investor rights cannot be conditional, and such rights cannot come back into existence once the loan is repaid or forgiven. The simplest way (and that most beneficial to the company) to address this would be to eliminate any blocking rights over day-to-day activities which an investor has. Given that these types of protections are fairly standard for venture capital and private equity investors, it is unlikely that investors would agree to eliminate these protections, unless there is a compelling rationale or need to do so that overrides the desire to maintain the control provisions.

Thus, companies and investors will need to find a middle ground. One potential solution would be to set the approval thresholds at a level which does not provide any one individual investor (or its director designee) with blocking rights over day-to-day actions. For example, the approval threshold for the stockholder protective provisions in a company’s certificate of incorporation (i) could be reduced such that no individual investor may block a company from taking these actions, (ii) could be amended to include the approval of a majority of the holders of common stock in addition to that of the investor, or (iii) could be set at a percentage of the common stock and preferred stock voting together. With respect to approval of a designated director, potential solutions for this issue include (i) requiring approval from a majority of the directors designated by all classes of preferred stock (if the subject company has conducted multiple financings) rather than from a certain specific director designee, (ii) requiring approval from a majority of a company’s board of directors (since all directors have fiduciary obligations to the company), or (iii) appointing independent directors (who own no equity in the company and do not have a relationship with the investor) and requiring a majority of the independent directors to approve these actions.

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