4-3-20 SBA Section 7(a) Paycheck Protection Program Affiliate Rules

This Client Alert supplements our March 26, 2020 Client Alert in which we reported that on March 27, 2020 President Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). That Client Alert describes in detail the new type of loan program known as the Paycheck Protection Program (the “PPP”) established by the CARES Act within the U.S. Small Business Administration’s (the “SBA”) Section 7(a) loan program. The PPP expands an existing SBA loan guarantee program for eligible small businesses and includes an increase in both the maximum loan amount the SBA can guarantee and the size of businesses eligible for the program.

An issue which a number of our clients have sought advice on is the applicability of the SBA affiliate rules to the SBA PPP eligibility requirements. In order to be eligible, a potential borrower must meet SBA size standards which are based on number of employees or revenue receipts during the covered period under one of the following:

Have no more than 500 employees.
Qualify under existing SBA loan eligibility rules using industry size standard or annual revenue receipts threshold.
Meet the SBA’s “alternative size standard.”

The SBA affiliate rules require that a potential borrower include all of the employees or revenue receipts of its domestic and foreign affiliates for purposes of determining if it meets these eligibility requirements.[1] The affiliate rule can have dramatic impact on the ability of investor-back businesses such as venture capital (“VC”) and private equity (“PE”) portfolio companies because of the requirement to include the employees or revenue receipts of the investor and the portfolio companies controlled by the VC, PE or other type of investor for purposes of determining eligibility. Speaker of the House Nancy Pelosi and Congressman Ro Khanna sent a letter on March 31, 2020 urging the US Department of the Treasury and the SBA to issue guidance explicitly including startups with equity investors among PPP eligible small businesses, and easing what have been overly strict applications of the affiliation rule. Unless and until responsive guidance is issued, we need to look to the affiliation rules to determine how the affiliation rules apply to potential investors.

There are two different SBA rules that the SBA has used in the past to determine whether a potential borrower has “affiliates” and it needs to include its revenue receipts or employees for purposes of eligibility calculations.

The first, and broader, of the two SBA affiliation rules is found in 13 CFR §121.103. The text of the CARES Act and FAQs and guidance published by the Senate Committee on Small Business & Entrepreneurship indicates that this rule may apply. This rule finds affiliation where multiple investors each own large percentages of an entity’s equity and together control that entity, even if none of them owns a majority of the equity. However, despite this early guidance to the contrary, we believe that 13 CFR §121.103 is not the rule that governs Section 7(a) loans.

We believe that the second, narrower, SBA affiliation rule, which is found in 13 CFR §121.301, should be used for PPP loan eligibility because the loans are made under Section 7(a). Under this regulation’s criteria, entities are deemed to be affiliates of each other if an investor controls or has the power to control the other, or a third party or parties controls or has the power to control both. Using this definition, affiliation based on equity ownership is irrefutably presumed when an investor “owns or has the power to control more than 50%” of the voting equity of an entity. Affiliation may also exist where there is a significant minority equity owner who also has protective voting rights or contractual governance rights that enable the equity owner to block or force certain actions. Other circumstances may also result in an entity being deemed an affiliate under the SBA rules, including, but not limited to, where there exist certain equity options, convertible securities, or agreements to merge, or if two entities have identical or substantially identical businesses or economic interests, or where there is a certain threshold of economic dependence.

It is important to note that the SBA will exercise subjective judgment and consider a totality of the circumstances in determining whether affiliation exists and may find affiliation even when no single factor alone is sufficient to constitute affiliation. This is a complex fact and circumstance analysis and potential borrowers should make sure they have thoroughly analyzed their equity ownership and all governance rights held by their significant investors. It may be helpful to answer these three questions to help determine a VC or PE backed entity’s eligibility:

does the VC or PE investor hold 50% or more of the entity’s equity; or
does any single VC or PE investor control a majority of the board of directors (or similar governing body); or
does any single VC or PE investor possess protective provisions or other contractual rights enabling it to block or force meaningful corporate action?

Regardless of whether the answer is “yes” to any of these questions, we highly recommend that VC and PE backed companies determine eligibility based on their affiliations prior to submission of a PPP loan application. In certain circumstances it may be advisable for these types of potential borrowers to remove or restructure governance rights that may lead to affiliation prior to such submission.

The SBA has now published the final PPP loan application. Notably, the application requires disclosure of and information regarding equity holders that own more than 20% of your business. It also asks whether the applicant or any owner of the applicant is an owner of any other business or has common management with any other business. Potential borrowers should be prepared to list all equity owners and be ready to disclose and discuss the rights granted to each of your owners (and the rights granted specifically to certain stockholders based on the class or series of shares held by those stockholders).

We expect the SBA to provide greater clarity on the affiliation rules and the process for applying for PPP loans in its regulations which are expected to be issued in the near future. Additional guidance from the US Department of the Treasury issued on April 2, 2020 did not address the issue of affiliation, but indicated that further guidance would be forthcoming.

Contact your Woods Oviatt attorney or the attorneys listed below regarding COVID-19 related issues.

[1] The CARES Act specifically waives the application of the SBA affiliation rules for accommodation and food service providers (which includes any business with not more than 500 employees that, as of the date on which the loan is disbursed, is assigned an NAICS code beginning with 72), franchises (which includes any business operating as a franchise that is assigned a franchise identifier code by the SBA) and SBIC-Funded businesses (which includes any business that receives financial assistance from an SBIC).

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https://www.woodsoviattgilman.com/covid19

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