We wrote about the Paycheck Protection Program (“PPP”) component of the CARES Act (“Act”) last week and how it expanded who is eligible for Small Business Administration (“SBA”) loans in response to the COVID-19 pandemic. One of its general qualifications is that the company must have no more than 500 employees.
One issue we are seeing is the SBA’s “affiliation” rules and how they are rendering many VC-backed startups ineligible for PPP loans based on this number-of-employee qualification. While the Act waives the affiliation rules for certain companies [See Footnote 1], others will continue to have to follow the rules.
When the SBA counts the number of employees of an applicant to determine whether the applicant has 500 employees or less, it will look to the number of employees of the company and the employees of its affiliates.
For several VC-backed companies, this means that SBA will aggregate all the employees of your company, and all the employees of the VC firm backing you, and the employees of the other companies that the VC firm “controls” (more on “control below). This could quickly push your company above the 500 employee threshold and render you ineligible for a PPP loan.
Among the several methods to determine affiliation under 13 CFR §121.301, the following seem to be the most problematic for VC-backed startups:
- Ownership: if one person or firm owns more than 50% of the voting shares in the company.
- Negative Controls: if a minority shareholder “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.”
- Management: if the CEO/President also controls the management of another business.
Note that with respect to items 1 and 2, the SBA will deem as exercised all options and convertible securities.
Guidance
If you are wondering whether any other business is an “Affiliate” of your company, there are some straightforward gut checks you can perform, and, if necessary, bring in attorneys to help you sift through anything that is more complex.
First, whether your CEO or President also controls the management of another company is easy enough to determine.
Second, look at your cap table. Does any one person or entity own more than 50%? Are those shares voting shares?
Third, look at your Certificate of Incorporation (for Delaware companies) or Articles of Incorporation (for Washington companies). Most if not all VC backed companies’ Certificate/Articles of Incorporation will contain what are known as “protective provisions,” that typically say the company may not do X,Y, or Z without the approval of a majority of a certain number of shares (sometimes only preferred stock, but may be more complex based on how many rounds of financing the company has undergone).
Can any one shareholder block any of the actions set forth below? For example, if the protective provision states that a majority of the holders of Series Seed Preferred Stock have to approve a certain action, does any one shareholder hold more than 50% of the Series Seed Preferred Stock?
Next, do the protective provisions themselves trigger “Affiliation”? The National Venture Counsel Association recently released an opinion on which do, and which do not, and many in the field are looking to this document as gospel for determining whether “Affiliation” is triggered. I would encourage you to compare the protective provisions listed in the document to yours, and see if any match up.
To remedy this Affiliation issue, the SBA has stated that if “a minority shareholder irrevocably waives or relinquishes any existing rights…..would no longer be an affiliate of the business (assuming no other relationship that triggers the affiliation rules”). A company can therefore request that any affiliate waive or relinquish any of its Affiliation-triggering rights.
Fourth, see if the shareholders of your company have executed any Voting Agreement, Investors’ Rights Agreement, or Management Rights Agreement. Sometimes these agreements will give one shareholder a disproportionate amount of control over the Company, or allow one shareholder to control the entire board of the company, which could trigger Affiliation.
Conclusion
The SBA Affiliation rules have made it more complex than anticipated for VC-backed startups to apply for PPP loans. Be sure to take into consideration the points above so you do not inadvertently disqualify your company for these loans.
If you have any questions on the above or about the Cares Act, please feel free to email me.
Helpful Links
We have found the following link helpful if you have any additional questions about anything above or about the Cares Act.
https://home.treasury.gov/system/files/136/Paycheck-Protection-Program-Frequenty-Asked-Questions.pdf
Disclaimer: this post is for informational/educational purposes only. It is not intended to provide any legal advice.
Footnote 1
The Act waives the SBA affiliation rules for these entities:
- Any Business concern with not more than 500 employees that is assigned a North American Industry Classification System code beginning with 72 (Accomodation and Food Services companies);
- Any business concern operating as a franchise that is assigned a franchise identifier code by the SBA; and
- Any business concern that receives financial assistance from a company licensed under Section 301 of the Small Business Investment Act of 1958 (Small Business Investment Companies).
For more related articles like the Cares Act, please visit our website, here.
By: James Graves
[responsivevoice_button voice=”UK English Female” buttontext=”Listen to Post”]