April 6, 2020
[Updated on April 7, 2020]
On April 6, 2020, the Small Business Administration (SBA) gave further detail on the guidance previously provided 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. While the further detail clarified some matters, this additional guidance unfortunately did little to solve the eligibility dilemmas of venture-backed companies.
Affiliate Determinations under SBA Framework for Paycheck Protection Program Loans
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 absent an industry-specific exemption or other means of qualifying as a small business concern.
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:
What is Negative Control?
Negative Control may be found when a minority owner can unilaterally prevent a Company from:
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):
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 potentially problematic control provisions be amended, waived, or otherwise modified to prevent minority investors from being deemed Affiliates?
Yes. The SBA has stated that the control rights of minority investors will not cause the investor to be deemed an “Affiliate” if the rights at issue are irrevocably waived or relinquished. To accomplish this, a company can amend the applicable documents or have the investor enter into a separate waiver for that purpose. Note that any amendment or waiver must be binding, permanent, and irrevocable to effectively remove Affiliate concerns. Further, any amendment to a company’s governing documents may require consent of other parties (e.g., a majority of the stockholders) to be effective. Because of the potential pitfalls, we would recommend that anyone intending to rely on this approach seek the opinion of counsel prior to submitting their application.
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.
Please see our prior client alerts, dated March 29, 2020, available at CARES Act Considerations for Emerging Companies and other Small Businesses and March 31, 2020, available at Interim Update – CARES Act Considerations for Emerging Companies and Other Small Businesses: The SBA Provides High-Level Guidance on the PPP for further details on the PPP and other SBA relief programs for Emerging Companies.
For additional information on COVID-19 related issues, please visit the Nelson Mullins COVID-19 resource page or contact a Nelson Mullins attorney.
These materials have been prepared for informational purposes only and are not legal advice. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Internet subscribers and online readers should not act upon this information without seeking professional counsel.