Venture-backed startups and other small businesses with investors or subsidiaries may not be eligible for the 7(a) small business loan program pursuant to the Paycheck Protection Program (PPP) due to the affiliation rule.

The small business lending facility under the PPP allocates $349B for small businesses. An eligible business may receive a low-interest loan of up to $10M of which 8 weeks-worth of payroll expenses may be forgiven, effectively turning into a grant. An eligible Small Business is typically a business with less than 500 employees, subject to some variations under the Small Business Administration’s (SBA) sizing standards.

Venture-backed startups may be acutely impacted as an investor may be considered an Affiliate if the investor has a certain ownership threshold or level of control. The application of the affiliate rule under the PPP is an evolving topic currently being addressed by regulators.

The Problem

Small businesses are eligible for loans under the PPP. As mentioned, a small business is generally a company with less than 500 employees. However, the SBA will include the total number of employees for the business and all affiliates. In many scenarios an investor will be an affiliate of several or possibly all portfolio companies. If so, all of the employees of each portfolio company and the investor will be included in the calculation of any one portfolio company.

In summary, the SBA will not only count the number of employees of the startup applying for the loan in this scenario. They will also include the number of employees for each startup in the investor’s portfolio which may exceed to 500 employee threshold, as shown here.

Interim Final Rule – April 2, 2020

The application of the affiliate rule under the PPP is addressed by the SBA’s interim final rule. This guidance does not make a substantial impact on the negative effect on startups. In summary, the standard identified under 13 CFR § 121.301 provides the definition of affiliate. Specifically, subsection (f) established a “totality of the circumstances” test maintaining the broad application of affiliation.

Examples of circumstances that will trigger the affiliation rule are when an investor or other entity:

  • owns 50% of more of a company’s voting stock;
  • has affirmative or negative controls such as the ability to prevent a quorum or block shareholder or board actions;
  • can declare a dividend payment;
  • hire or fire employees, or determine employee compensation; or
  • change the company’s line of business.

(This is not exclusive; other scenarios may trigger the affiliate rule.)

Additional Guidance from US Chamber of Commerce – April 7, 2020

Further guidance issued by the SBA addresses the PPP generally, which includes the affiliation rule. Regarding affiliation, there are two key highlights:

  • Lenders do not need an independent verification of affiliate status, and can rely on the certification of the borrower; and
  • A shareholder or investor waiving their rights that conflict with the control requirements, they will not be deemed an affiliate.

The second point enables investors previously treated as affiliates to forego those rights. Bylaws and Investor Rights Agreements may be amended to remove any control rights of an investor to avoid triggering the affiliation rule.

What’s Next?

We anticipate additional guidance and clarifications to be offered in the coming weeks regarding affiliation under the PPP. As the rule currently stands, investors and companies should review their charter, bylaws, and investor rights to determine whether the affiliation rule applies. If so, these documents may be amended to avoid the implication of the affiliation rule.

This post is provided for general information purposes and is not legal advice.  As always, if you have any questions about this post or how it might impact your business, contact one of our attorneys.