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SBA Affiliate Rules & CARES Act Eligibility: What VC-backed Companies Need to Know

Since the passage of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, most companies have been scrambling to determine if they will be eligible for any of the relief made available in the legislation. Venture capital-backed companies have been significantly impacted by COVID-19, and many are facing an additional challenge in determining their eligibility for some of the CARES Act programs with the Small Business Administration's (SBA) affiliate rules.

Why are the SBA's affiliate rules important?

In order to be eligible for significant components of the CARES Act benefits, a company must meet the definition of a “small business” as defined by the SBA. One of the requirements to be considered a small business is having 500 or fewer employees. Under the SBA’s affiliation rules, your employee headcount is required to be combined with the headcount of all of your company’s affiliates. For a VC-backed company, your VC investors could be considered affiliates, which would significantly impact your employee headcount for purposes of the CARES Act programs.

What CARES Act benefits are impacted by this small business definition?

Most importantly, the $349B Payroll Protection Program (PPP) is only available to small businesses. In addition, the Economic Injury Disaster Loans (EIDL), authorized under the earlier Coronavirus Preparedness and Response Supplemental Appropriations Act, also require participants to be small businesses. The CARES Act made a special $10B appropriation for emergency EIDLs.

What types of relationships or conditions might create an “affiliation”?

The key concept here is “control.” In some instances, control is clear. If a single stockholder owner has 50% or more of the voting stock of an entity, that stockholder would generally be considered to have control of that entity. In these situations, the stockholder would be considered to have “positive control,” meaning their voting interest can cause the company to take specific actions.

But control can also exist when a stockholder holds only a minority interest in the voting stock. This is the typical situation with a VC investor.

It’s important to note that the SBA’s affiliate guidance is fairly broad and has been substantively interpreted and clarified via case law. Before making any final determinations, you should consult with your legal counsel.

Generally, a minority stockholder is considered to have control if they can block or prevent the board of directors (or the rest of the stockholders) from taking actions. This is known as “negative control”—while not being able to cause an entity to take an action, the investor exerts control by preventing an entity from taking actions. It’s very common for VCs to have certain blocking or preventative rights that will need to be reviewed and considered.

How should you go about considering the various rights that have been conferred on your investors in your Corporate Charter or Certificate of Incorporation? 

The important distinction to make is whether the rights are of an operational nature or are of a nature designed to allow an investor to protect the value of their investments.

What are examples of day-to-day operational decisions that, if a minority stockholder could block or prevent, could cause that stockholder to be considered an affiliate?

a.Employee compensation matters

b.Hiring and terminating officers and executives

c.Creating or changing a stock option plan

d.Incurring debt

e.Establishing a company's budget including its capital budget

What are examples of rights that are designed to allow an investor to protect their investments?

a.Entering into a merger transaction

b.Issuing additional stock

c.Changing the company's primary business

d.Amending the company's governing documents

e.Selling all (or a substantial amount) of the company's assets

f.Changing the size of the board of directors

An important point to note is that, for purposes of these affiliate analyses, all convertible instruments outstanding are considered exercised or converted. As a result, those instruments could change a stockholder’s ownership percentage for purposes of this analysis. You would also need to consider any additional rights a stockholder could obtain if convertible instruments were exercised. The types of instruments involved include options, warrants, and convertible debt.

What other situations could create affiliation with another entity? 

The other situation to consider is common control. If executives or directors of a business control the board of and/or management of another business, that other business could be considered an affiliate.

Example 1

One of the co-founders of TechCo A is the owner and manager of a non-US entity that TechCo A uses for software development services. That non-US entity could be considered an affiliate of TechCo A.

Example 2

The founder of ProfServiceCo A spun off a products company, ProdCo B, and the founder is a majority owner of both companies. ProfServiceCo A and ProdCo B could be considered affiliates.

If a stockholder is determined to have control of another entity based on the factors outlined above, or for any other reason, not only is that stockholder an affiliate of the entity, but every other entity that stockholder controls is also considered an affiliate. If you think about your VCs and the number of entities that they may be determined to control under these rules, you can see how problematic this issue can become.

Ultimately, the SBA looks at the "totality of the circumstances" in making determinations on affiliation.  This means no single factor is determinative. Each company will need to consider all relevant facts and circumstances. This is why it’s critical to work with your legal counsel, your board, and your investors before making a final determination.

How will the SBA obtain information about my company’s affiliates?

It’s up to each company to make a determination on its eligibility for any benefit received under the CARES Act, including the PPP loan program. That includes determining if the company meets the definition of a “small business” with the 500 employee limit. This would require evaluating the SBA’s affiliate rules.

Additionally, in the PPP loan application form under the Applicant Ownership section, you will need to individually list each stockholder that holds a greater than 20% interest. In Question 3 of that section, you are asked if the company, or any owner of the company, is an owner of any other business, or if there is common management. If so, you are required to list each business in an addendum with a description of the relationship to your company. Finally, on page two of the application, you are required to specifically certify that you are eligible to receive a loan under the CARES Act and SBA rules which would include SBA's affiliate guidance.

What should you do now?

In consultation with your legal counsel and board, review the following in order to start the process of identifying potential affiliates:

a.Direct ownership interests held

b.Convertible instruments held

c.Rights held by investors as outlined in financing documents, corporate charters, and certificates of incorporation

Next, you should review the SBA's PPP loan application in detail. With this information, you can start to determine your company’s affiliates. You can then start discussions about what changes can be implemented to alleviate any affiliation concerns (i.e. amending documents to eliminate certain investor rights).

Where can you find more information?

The regulations are available on the Electronic Code of Federal Regulations website and the SBA's affiliation rules.

The National Venture Capital Association (NVCA) has been active highlighting the SBA’s affiliation rules and lobbying for changes to the PPP application. Read more:

Conclusion

The rules and guidance for the PPP and all the provisions of the CARES Act are still in progress. New guidance is issued daily, so be sure to check back regularly for updated information.

Also, remember that the PPP loans are only one part of the CARES Act. Even if you determine that you don’t qualify for the PPP, there is another $454B authorized in the CARES Act for companies determined to have more than 500 employees. Guidance for how this money will be made available has yet to be issued. Stay tuned for further insights and updates.