In recent months, there have been a number of articles about an increase in venture capital interest in entities that do business with the federal government. In fact, this interest is not new. Small entities with venture backing have used programs like the Small Business Innovation Research (SBIR) program to obtain early stage research and development funding and government entities, like the Department of Defense, have tried to encourage smaller firms with cutting edge technology to enter the federal market. However, traps for the unwary remain. Specifically, many small businesses and venture capital firms assume that minority investments on standard market terms will not change a company’s status under the Small Business Administration (SBA) affiliation rules. This assumption can be a mistake and is one of the most common pitfalls we see companies get caught in when making a minority investment in a small business.

To calculate the size of a business for purposes of SBA small business rules, SBA aggregates the number of employees or annual receipts of the business with those of all of its affiliates. Under the SBA rules, affiliation includes both exercised and potential control ‒ both affirmative and negative control. To avoid the small business becoming affiliated with its minority investors (and perhaps its other investments) for purposes of determining the size of the small business, such minority investors cannot have control over the small business’s day-to-day actions.

SBA’s Office of Hearing and Appeals (OHA) case law has explained that the following activities constitute day-to-day actions that a small business must maintain exclusive control over:

• Paying dividends;

• Forming a quorum of shareholders;

• Determining employee compensation;

• Hiring and firing executives;

• Blocking “any changes in the [company’s] strategic direction”;

• Committing any act that would alienate or encumber a concern’s assets;

• Amending or terminating existing lease agreements;

• Purchasing equipment;

• Incurring debts or obligations (even if a dollar threshold is established);

• Selecting independent auditors;

• Choosing accounting methods; and

• Making changes to the budget.

This list is not exhaustive, and case law is constantly developing to highlight additional actions that SBA considers to be day-to-day. However, here’s the important point ‒ many of the terms used in venture capital investments (such as the National Venture Capital Association (NVCA) form certificate of incorporation and investor rights agreement) contain controls that would be deemed to result in a venture capital firm having negative control over the small business, and thus result in affiliation under the SBA rules ‒ and perhaps making that business ineligible for SBIR or other small business contracts. A few examples of such standard terms that could (and in some instances likely would) result in affiliation under SBA rules include, but are not limited to, the following:

• Create, or authorize the creation of, or issue, or authorize the issuance of any debt security or create any lien or security interest (except for purchasing money liens or statutory liens of landlords, mechanics, materialmen, workmen, warehousemen and other similar persons arising or incurred in the ordinary course of business) or incur other indebtedness for borrowed money, including, but not limited to, obligations and contingent obligations under guarantees, or permit any subsidiary to take any such action with respect to any debt security lien, security interest or other indebtedness for borrowed money[, if the aggregate indebtedness of the corporation and its subsidiaries for borrowed money following such action would exceed $_____] [other than equipment leases, bank lines of credit or trade payables incurred in the ordinary course] [unless such debt security has received the prior approval of the board of directors, including the approval of [at least one] preferred director];
• Purchase or redeem (or permit any subsidiary to purchase or redeem) or pay or declare any dividend or make any distribution on, any shares of capital stock of the corporation other than (i) redemptions of, or dividends or distributions on, the preferred stock as expressly authorized herein, (ii) dividends or other distributions payable on the common stock solely in the form of additional shares of common stock and (iii) repurchases of stock from former employees, officers, directors, consultants, or other persons who performed services for the corporation or any subsidiary in connection with the cessation of such employment or service at no greater than the original purchase price thereof [or (iv) as approved by the board of directors, including the approval of [at least one] preferred director];
• Create, or authorize the creation of, or issue, or authorize the issuance of any debt security or create any lien or security interest (except for purchasing money liens or statutory liens of landlords, mechanics, materialmen, workmen, warehousemen and other similar persons arising or incurred in the ordinary course of business) or incur other indebtedness for borrowed money, including, but not limited to, obligations and contingent obligations under guarantees, or permit any subsidiary to take any such action with respect to any debt security lien, security interest or other indebtedness for borrowed money[, if the aggregate indebtedness of the corporation and its subsidiaries for borrowed money following such action would exceed $_____] [other than equipment leases, bank lines of credit or trade payables incurred in the ordinary course] [unless such debt security has received the prior approval of the board of directors, including the approval of [at least one] preferred director];
• Make, or permit any subsidiary to make, any loan or advance to, or own any stock or other securities of, any subsidiary or other corporation, partnership, or other entity unless it is wholly owned by the company;
• Guarantee, directly or indirectly, or permit any subsidiary to guarantee, directly or indirectly, any indebtedness except for trade accounts of the company or any subsidiary arising in the ordinary course of business;
• Incur any aggregate indebtedness in excess of $[_____] that is not already included in the budget, other than trade credit incurred in the ordinary course of business;
• Hire, terminate, or change the compensation of the executive officers, including approving any option grants or stock awards to executive officers;
• Sell, assign, license, pledge, or encumber material technology or intellectual property, other than licenses granted in the ordinary course of business; or
• Enter into any corporate strategic relationship involving the payment, contribution, or assignment by the company or to the company of money or assets greater than [_____] dollars ($[_____]).

So, if you have an outside investment with these terms and are bidding on small business contracts with the federal government, you are at significant risk of not only losing a size protest but, in some instances, you may face action under the False Claims Act.

Case law and guidance from SBA also clarifies that minority investors may take actions that are meant to protect their own interests, rather than impede a small business’s ability to control its day-to-day operations. In other words, a minority investor may block extraordinary actions without SBA finding the minority investor has negative control over the small business. Although there is no bright-line test for what meets this standard, OHA has found that a minority investor can block the following extraordinary actions without the result of its actions becoming a finding of control by minority investors:

• Selling all or substantially all of a company’s assets;

• Mortgaging or placing an encumbrance upon all or substantially all assets of a company;

• Engaging in any action that could result in a change in the amount or character of a company’s contributions to capital;

• Changing the character of a company’s business;

• Amending a concern’s charter, bylaws, operating agreement, or the articles of organization;

• Taking an action in contravention of a concern’s operating agreement;

• Committing any act that would make it impossible for a company to carry on its ordinary course of business;

• Disposing of the goodwill of a company;

• Correcting a false or erroneous statement in a concern’s articles of organization;

• Submitting a company’s claim to arbitration;

• Confessing about a judgment;

• Initiating litigation;

• Issuing additional stock;

• Entering into substantially different lines of business;

• Adding new members;

• Dissolving the company;

• Approving an increase or decrease in the size of the concern’s board;

• Approving an increase or decrease in the number of authorized interests, or reclassifying interests;

• Amending the operating agreement in any manner that materially alters the rights of existing members; and

• Filing for bankruptcy.

Navigating the line between day-to-day management and extraordinary actions and staying attuned to further developments in case law that provide additional data points about what falls on either side of that line are critical for both small startups and investors. However, the key action item for investors and small businesses is to review their current agreements and, at minimum, eliminate any of the prohibited negative controls before submitting future small business proposals.

You can gain an invaluable amount of the knowledge needed to manage the legal aspects of launching, funding, and growing a startup, with insights to avoid many common mistakes that can have serious consequences down the road at MoFo ScaleUp.

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