Venture-backed companies did not receive the relief they had hoped for this past Friday, April 3rd, when the Small Business Administration (“SBA”) issued affiliation rule guidance on the Paycheck Protection Program (“PPP”) created under the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). The guidance largely affirms existing SBA regulations as they previously applied to SBA 7(a) loans and includes no affiliation rule waiver other than the limited waivers in the CARES Act. The absence of an applicable waiver means most venture-backed companies will need to include employees of other portfolio companies of their VC investors in determining whether they fall below the 500 employee limit for PPP eligibility. Without any further relief, PPP loans will not be extended to venture-backed companies, many of which are vital in the fight against the Coronavirus pandemic.
The CARES Act temporarily adds a new Paycheck Protection Program to the SBA’s 7(a) loan program providing guarantees for forgivable loans of up to $10 million (capped at $349 billion in the aggregate). The PPP is intended to provide economic relief to small businesses adversely impacted by COVID-19. An entity is generally eligible for the PPP if it, combined with its “affiliates”, has 500 or fewer employees whose principal place of residence is in the United States or is a business that operates in a certain industry and meets applicable SBA employee-based size standards for that industry. If two or more companies are deemed affiliates of each other, all employees of each of the affiliated entities are aggregated for the purpose of calculating the 500 employee threshold.
Without a waiver of the SBA affiliation rules, venture backed companies would be deemed affiliates of all other companies in their VC investor’s portfolio and would be required to aggregate employee numbers with those of the other portfolio companies. Moreover, many venture backed companies have multiple VC investors. Some receive investment from corporate VCs, where the related corporate entity single-handedly employs more than 500 persons.
On April 3, the SBA issued guidance on application of the SBA’s affiliation rules to the PPP in the form of an interim final rule and a summary of the applicable affiliation tests (together, the “PPP Affiliation Guidance”). The day before the release of the PPP Affiliation Guidance, House minority leader Kevin McCarthy told the Axios Pro Rata Podcast the waiver would happen: “I just got off the phone with Treasury Secretary Mnuchin and this is going to be solved.” Speaker Nancy Pelosi also pushed for relief. Nevertheless, the PPP Affiliation Guidance gave venture backed companies no satisfaction.
Determining Affiliate Status
Under the PPP Affiliation Guidance, any of the circumstances described below would be sufficient to establish affiliation for applicants for the Paycheck Protection Program.
- Affiliation based on ownership. An entity is an affiliate of another entity that owns or has the power to control more than 50 percent of the first entity’s voting equity. If no individual or entity is found to control, the SBA will deem the board of directors or president or chief executive officer (or other officers, managing members, or partners who control the management of the entity) to be in control of the entity. The SBA will deem a minority shareholder to be in control, if that individual or entity has the ability, under the concern’s charter, by-laws or shareholder’s agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders.
- Affiliation arising under stock options and convertible securities. In determining size, the SBA considers stock options, convertible securities and agreements to merge (including agreements in principle), to have a present effect on the power to control an entity. The SBA treats such options, convertible securities and agreements as though the rights granted have been exercised. An individual or other entity that controls one or more other entities cannot use options, convertible securities or agreements to appear to terminate such control before actually doing so. The SBA will not give present effect to an individual’s or entity’s ability to divest all or part of its ownership interest in order to avoid a finding of affiliation.
- Affiliation based on management. Affiliation arises where the CEO or president (or other officers, managing members or partners who control management) also controls the management of one or more other concerns. Affiliation also arises where a single individual or entity that controls the board or management of one entity also controls the board or management of one of more other entities. It also arises where a single individual or entity controls the management of the applicant entity through a management agreement.
- Affiliation based on “totality of the circumstances”. The SBA may consider all connections between the borrower and a possible affiliate and, if no single factor is sufficient to constitute affiliation, the SBA may determine on a case-by-case basis that affiliation exists when there is “clear and convincing evidence” based on the totality of the circumstances.
Who’s in Control?
VC funds typically own less than 50% of the voting securities of their portfolio companies, primarily to preserve proper management incentives, and compensate for its minority position by negotiating for certain control rights. In the VC context, affiliation typically comes down to an analysis of those control rights. Because SBA affiliation rules do not specify the exact control rights that will or will not trigger affiliate status, determinations must be made on a case-by-case analysis of relevant administrative case law guidance to determine loan eligibility.
Based on a review of SBA Office of Hearings and Appeals (the “OHA”) case law, the National Venture Capital Association put together a handy list of block rights which would constitute the type of control sufficient to trigger affiliate status.
The existence of a block right by a VC fund, exercisable either by the fund itself at the stockholder level or by its designee(s) at the board level, over any of the following actions would likely constitute the type of control that triggers affiliate status for PPP eligibility purposes:
- 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 the company’s budget or approving capital expenditures outside the budget.
- Determining employee compensation.
- Hiring and firing officers and executives.
- 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.
Out of Control
By contrast, the NVCA’s review of OHA case law shows that VC funds may have block rights over the following extraordinary decisions without triggering affiliate status:
- Selling all or substantially all of the company’s assets.
- Placing an encumbrance or lien on all or substantially all of the company’s assets.
- Engaging in any action that could result in a change in the amount or character of a company’s capital contributions.
- Changing the company’s line of business.
- Engaging in a merger transaction.
- Issuing additional stock/equity.
- Amending the organizational documents of a company.
- Filing for bankruptcy.
- Amending the governing documents to materially alter the rights of the existing owners.
- Dissolving the company.
- Increasing, decreasing, or reclassifying the authorized capital of the company.
- Increasing or decreasing the size of the board.
- Entering into a confession of judgment.
- Disposing of the goodwill of the company.
- Committing to take any action that would make it impossible for the company to carry on its ordinary course of business.
As of now, many of the companies that would be excluded from PPP loan eligibility by a strict read of the SBA’s affiliation rules are precisely the innovative emerging companies vital to the fight against the new Coronavirus, namely biotechs developing vaccines and therapies, technology companies developing testing solutions, medical device companies and PPE companies. For that reason, it is expected that there will be continuing pressure for a regulatory or legislative fix for the affiliation rule problem as it would impact venture-backed companies. Whether the fix arrives in time is anyone’s guess. The PPP will be open only until the earlier of either June 30, 2020 or when the $349 billion cap in funding is exhausted.