COVID Legal Briefing – SBA 7(A) Loan Programs: Affiliation Considerations For Startups

The Coronavirus Aid, Relief, and Economic Security (CARES) Act was recently signed into law, and includes, among other things, a new loan type under the 7(a) loan program of the Small Business Administration (SBA), called the Paycheck Protection Program (PPP). Also available under the SBA framework are Economic Injury Disaster Loans (EIDLs). Our focus here is specifically on potential issues emerging growth companies may face in the context of these loan programs regarding deemed “affiliation” between a company and its investors.

Why does affiliation matter? Understanding whether an applicant’s investors will be deemed to be affiliated is important to ensure that an applicant does not breach a maximum level of employees required for eligibility under the loan programs. In order to be eligible for 7(a) loan programs, an applicant must employ no more than 500 employees.[1] For many early-stage companies, the 500 employee threshold would at first glance appear to be easily satisfied, but the SBA 7(a) loan programs require that an applicant includes in its headcount the employees of any companies under common control, or affiliated, with the applicant. For the SBA’s purposes, affiliation is defined more broadly than in many other contexts, and currently available guidance suggests that some common contractual rights held by venture capital investors could trigger a finding that an investor such as a VC fund would be affiliated with the applicant and that in turn the other portfolio companies of such fund would be deemed affiliates and be required to be included for purposes of the 500 employee threshold.

What triggers a finding of “affiliation”? There are several bases on which affiliation may be found, including the following:[2]

1.  Majority ownership. This is likely the easiest category to assess. If an investor owns more than 50% of the voting equity, that investor controls the company and shall be affiliated with the company, along with any other companies that such investor controls.

2.  Veto rights, aka protective provisions or negative controls.

a.  This is the category that has caused the most confusion in the startup ecosystem. A minority investor may, notwithstanding the minority ownership position, be deemed an affiliate based on its ability to negatively control (i.e., have veto power over) the applicant’s operations. Since most VC investors take minority positions, this is where most of the action is for assessing a startup’s likelihood of triggering a finding of affiliation with its investors.

b.  There is, unfortunately, no bright-line list of triggering provisions, but there are past decisions by the SBA Office of Hearings and Appeals (OHA) from which guidance can be drawn. Generally, the SBA focuses a finding of affiliation by negative control on whether the negative controls are operational in nature, as opposed to fundamental matters seen as reasonable for protection of a minority investor’s interests. Thus, a right to veto a sale of the company is unlikely to result in a finding of affiliation, but a right to veto capital expenditures probably would trigger such a finding.

c.   The National Venture Capital Association (NVCA) has put out a helpful summary of veto rights that, based on past OHA determinations, are likely to trigger a finding of affiliation with an investor holding any such rights (though it is important to bear in mind that removing any such negative controls does not guarantee that no finding of affiliation will be found). Those veto rights that are likely to be problematic are summarized below:[3]

i. Making distributions or paying dividends (other than tax distributions).
ii. Establishing a quorum for a board or stockholders meeting.
iii. Approving the budget or capital expenditures outside the budget.
iv. Determining employee compensation.
v. Hiring and firing officers.
vi. Changing the company’s strategic direction.
vii. Establishing or amending an option plan.
ix. Incurring or guaranteeing debts.
x, Initiating or defending a lawsuit.
xi. Entering into contracts or joint ventures.
xii. Amending or terminating leases.

d.  A couple of additional important considerations:

i.  Negative control is assessed not only with respect to the investor entity as an equity holder having blocking rights but also where an investor-appointed director has the ability to block actions at the board level.

ii.  Negative control is assessed with respect to a minority investor acting alone. However, this does not mean that the investor must have a right granted specifically to them; rather, a company must look at its ownership. For instance, if negative controls are granted to a company’s Series A holders as a group, and a single investor holds a majority of the Series A voting power, that investor constructively holds the veto right and will be found to hold those negative controls. In contrast, if an investor holds a large portion of the Series A but not a majority, this large ownership stake alone is unlikely to result in a finding that such investor holds those negative controls, because they do not, acting individually, have a blocking right.

3.  Convertible or exercisable securities, or agreements to sell. The SBA will give present effect, i.e. deem to have occurred for purposes of the affiliation analysis, any convertible instruments or agreements to sell. This includes, for instance, taking into account exercisable securities for calculating ownership thresholds, as well as in certain cases letters of intent to merge or sell securities.

4.   Management. Entities under common management may be deemed to be affiliated. This may include, for instance, where one entity controls the management of the applicant through a management agreement, or where one or more officers of the applicant control the management and/or the board of one or more other entities.

What if an investor has rights that would trigger affiliation, but they do not exercise them? For purposes of the SBA 7(a) loan programs, affiliation is measured based on rights held, regardless of whether such rights are exercised.

What actions should a startup take now? We recommend all startup companies applying for an SBA 7(a) loan familiarize themselves with the rights held by their investors. If an applicant has agreements in place with investors that are likely to trigger a finding of affiliation, it may be possible to amend those agreements to mitigate the likelihood of a finding of affiliation.

Will these guidelines change? There are substantial efforts in progress by the NVCA and other groups lobbying for guidance to clarify affiliation matters and ensure that startups are not inadvertently deemed affiliated with their investors by virtue of control provisions. There is no guarantee such efforts will be successful, and unless and until they are, companies will need to operate assuming the currently available guidance will apply. On Thursday April 2, 2020, House Minority Leader Kevin McCarthy (R-Calif.) told the Axios Pro Rata Podcast[4] that he spoke with Treasury Secretary Mnuchin and that guidance would be forthcoming in a couple of days to set out clearer guidelines for PPP loan eligibility.

Author: Caroline Cherkassky

The attorneys of Stubbs Alderton & Markiles, LLP are continuously monitoring the current COVID-19 situation and publishing relevant updates that pertain to your business. Contact one of our legal professionals at info@stubbsalderton.com, if you have any questions.

For more information please visit our COVID-19 Resources page.

[1] Note that there are exceptions for certain franchises or applicants in the hotel or foodservice industry, but these exceptions will not be relevant for most technology or other startups.

[2] This is a non-exhaustive list of the bases most likely to be relevant for startups. See 13 CFR §121.301(f) for a complete listing.

[3] See NVCA Affiliation in the Context of SBA Loans – Guidance for Venture Capital Investors at https://nvca.org/wp-content/uploads/2020/03/VC-SBA-Lending-and-Affiliation-Guidance-for-SBA-Loan-Programs.pdf

[4] See https://www.axios.com/coronavirus-vc-startups-small-business-loans-6ae9e125-fbbb-4349-9d67-ce68d4a5ac57.html.