Guidance for VC-Backed Companies Seeking SBA Paycheck Protection Program Loans Under CARES Act

Holland & Knight LLP

Highlights

  • The CARES Act makes available U.S. Small Business Administration (SBA) Paycheck Protection Program (PPP) loans for small businesses to support ongoing operations in light of economic uncertainty caused by the COVID-19 pandemic.
  • For Venture Capital (VC)-backed companies, several factors must be considered with respect to their eligibility for the PPP loans.
  • These issues include whether the employees of a company's investors and the investors' other portfolio companies must be counted for determining whether a company is a small business and how "necessity" for a PPP loan is determined.

The U.S. Small Business Administration (SBA) Paycheck Protection Program (PPP) loans available under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) are intended for small businesses to support ongoing operations in light of economic uncertainty caused by the COVID-19 pandemic. Venture Capital (VC)-backed companies have sought guidance primarily on two issues with respect to their eligibility for PPP loans:

  • When must the employees of a company's investors and those investors' other portfolio companies be counted for determining whether a company is a small business?
  • How is necessity for a PPP loan determined?

The relevant regulations, agency guidance and case law on these issues are not crystal clear. They require a consideration of the "totality of the circumstances" in each case, so it is difficult to offer "bright line" guidance applicable in all or most cases. While the guidance provided here is general, it should apply to many companies. Each company ultimately should consult with a lawyer to analyze its unique facts and circumstances, as well as determine its eligibility.

SBA Affiliation Rules

Overview

  • For purposes of determining whether a company is a small business entitled to apply for a PPP loan, the SBA affiliation rules require a company to include employees of its investors and their other portfolio companies in its own headcount if those investors are "affiliates" under the affiliation rules.1
  • Two tests are used to determine whether a company is affiliated with any of its investors: ownership and control.
  • Both tests must be applied to each investor. If either test is failed, the investor's own employees, and that of any other employer it also controls, must be counted.
  • Employees outside the United States (of the company and each of its affiliates) also must be counted.2
  • The CARES Act waives the affiliation rules requirements for companies in North American Industry Classification System (NAICS) Code 72 (accommodations and food service industry). Companies within NAICS Code 72 do not need to conduct an affiliation analysis. If a NAICS Code 72 company has multiple locations, the 500-employee limit applies to each location.

Ownership Test

  • The ownership test is met if no single investor (or group of related investors)3 controls more than 50 percent of the company's voting equity.

Control Test

  • If no investor (or group of related investors) holds more than 50 percent of a company's voting equity, then according to SBA guidance, the SBA may nonetheless consider a minority shareholder to be in "control" of the company if it can "prevent a quorum or otherwise block action by the board of directors or shareholders" on matters the SBA considers to be ordinary.
  • Ordinary matters are operational (i.e., matters the SBA considers to arise in the ordinary course of the day-to-day operations of a company).
  • In the VC-backed company context, this sort of control normally exists, if at all, through protective provisions or other "negative control rights" (blocking votes or approval requirements) associated with the preferred shares held by an investor or with specific approval rights granted to a member of the board of directors who an investor has the right to designate.
  • If a minority investor (or group of related investors) acting alone could exercise a protective provision or similar right to block an action the SBA considers ordinary, that investor is considered an affiliate of the company under the control test.
  • Examples of actions the SBA considers "ordinary," and which often are the subject of a protective provisions or a similar right, include the following:
    • declaring or paying dividends (other than tax distributions)
    • approving or altering a company's budget or major, unbudgeted expenses
    • setting employee compensation
    • hiring and firing officers and directors
    • making changes in the company's strategy
    • incurring or guaranteeing debts
    • entering into contracts
    • establishing joint ventures
  • If the combined headcount of the company, a minority investor that can control the company's ordinary actions and all of the employees of other affiliates of a controlling minority investor (e.g., other portfolio companies it controls) would disqualify the company as a small business, this problem can be remedied if the minority investor's control rights over ordinary actions are eliminated before the company applies for a PPP loan.
  • Many other actions typically subject to protective provisions or similar rights are not considered by the SBA to be ordinary actions, so an investor can have the power to block those actions without being deemed an affiliate under the control test. These extraordinary actions include selling all or substantially all of the company's assets or placing a lien on them, merging with another company, issuing more stock or other equity, amending the company's organizational documents, changing the company's principal line of business or dissolving the company.

Necessity Determination

Overview

  • The PPP loan application requires an applicant to certify in good faith that "Current economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant."
  • The easy case regarding "necessity" is an applicant that has or will have to lay off employees and/or reduce compensation unless it receives a PPP loan. However, nothing in the statute limits "necessity" to businesses that have laid off employees or cut compensation. There are other businesses that may have some reduced revenue and are worried about impacts in May, June and July to existing revenue, new work and the ability to recruit employees.
  • Currently, neither SBA nor the U.S. Department of the Treasury has provided any guidance beyond the certification language regarding what rises to the level of making a PPP loan "necessary" to support ongoing operations.

Given the real hardship faced by companies that may presently be able to carry their employees, companies need guidance about how best to protect themselves when making this certification in light of the current regulatory uncertainty. Enforcement authorities in the future may look back on the "necessity" standard with a more stringent lens. With this in mind, the following policies and practices should be followed to help mitigate compliance and enforcement risk.

Necessity Justification

  • An applicant for a PPP loan should consider (and document, as indicated below) the following factors, among others it deems relevant:
    • its understanding of the "current economic uncertainty"
    • its current understanding of how "ongoing operations" have been impacted to date by this economic uncertainty
    • its understanding of risks and reasonable expectation of future impacts that may occur in the next few months if the current economic uncertainty is not abated
    • how and why the loan is necessary to support ongoing operations given the conditions and impacts identified

Documentation of Necessity Justification

  • To help mitigate future compliance or enforcement risk, it would be helpful for a company to have an internal document that explains its situation and rationale at the time it makes the certification that the loan is "necessary to support ongoing operations." A well-reasoned, factually accurate document could blunt the scienter (intent) element under the criminal and civil statutes that the government could invoke in the future (Civil False Claims Act; Bank Fraud; Mail and Wire Fraud; Criminal False Claims Act, to name some). Conceptually, this document is similar to a "justification and approval" or "determinations and findings" memo.
  • Among other relevant information and considerations, the internal document should include a description of the company's understanding regarding each of the four factors indicated above.
  • To the extent the lender asks any questions when considering the company for a loan, all responses should be consistent with this internal justification.
  • While this internal justification is no guaranty, it can help demonstrate that the company did not act with knowledge that its certification was false or with either reckless disregard or deliberate ignorance of the truth or falsity of its certification. To be effective, it is important for the justification to be accurate and truthful.

Notes

1 An employer for SBA purposes can be an individual or a type of "concern" other than a corporation or limited liability company (LLC), but most venture capital (VC)-backed companies are corporations or LLCs that issue voting equity interests (stock or LLC units) to their investors. Similarly, most significant investors in VC-backed companies are themselves corporations or, more commonly, LLCs (or partnerships, which are similar to LLCs). This guidance is premised upon these assumptions, but bear in mind that there may be cases in which a company has a significant investor who is an individual or that is another type of "concern." Such parties also can be employers.
2 Foreign companies with employees in the United States also can apply for a PPP loan, but loan proceeds can be used only to pay employees in the United States or other permitted expenses in the United States.
3 Investors can be related by virtue of common/overlapping ownership (e.g., two funds of different vintages managed by one venture capital firm), by agreement or other legal arrangement (e.g., a voting trust) or by a family relationship.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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