The following has been summarized for FML audiences from a synopsis of the CARES Act titled “Affiliation in the Context of SBA Loans – Guidance for Venture Capital Investors” provided by the National Venture Capital Association (NVCA) as of March 27, 2020.
The CARES Act expanded financial assistance available to qualifying small businesses through 7(a) loans under the new Paycheck Protection Program (PPP) and the 7(b)(2) economic injury disaster loans.
To be eligible for this assistance, a business must have:
1) fewer than 500 employees
2) fewer than the number of employees the SBA has designated as the size standard based on a company’s applicable 6-digit NAICS code, whichever is GREATER.
With limited carve-out exceptions, the SBA affiliation rules will play a determining factor as to eligibility of a particular business regarding an SBA loan. This could have a significant impact on venture capital-backed companies.
Business entities are considered to be affiliates of one another by the SBA when:
- one controls or has the power to control the other
- a third party or parties controls or has the power to control both.
In either circumstance, the evaluation of control needs to be determined based upon equity ownership and control rights.
Ownership of greater than or equal to 50% of the voting securities of a business will constitute control and therefore trigger affiliation between the business applying for assistance and the majority holder and other businesses deemed to be controlled by the same majority holder.
If there is less than 50% ownership by a VC holder, the “control rights” of the minority investors need to be evaluated.
A minority holder with the following high risk “control rights” will result in a high likelihood that it will be considered affiliated with the company:
- Ability to prevent a quorum or otherwise block board or stockholder actions such as:
- Making distributions or dividends
- Approving or changes to budgets or capital expenditures
- Determining employee compensation and hiring and firing decisions
- Strategic direction
- Employee stock ownership plans
- Debt related decisions
- Contract/Joint venture decisions/Lease decisions
The SBA has permitted minority owners to have control over certain company decisions that are considered extraordinary, rather than day-to-day operational decisions. Most of these negative controls are in place in order to protect the value of their investment and would not trigger affiliation.
We have the following recommendations for VC backed companies prior to applying for a SBA loan:
- Conduct a close examination of investment and governance documents to determine if affiliation issues exist
- Consider amending governance documents to mitigate any control rights that are considered high risk
- When applying, highlight how minority investors have only limited control over certain extraordinary actions that are linked directly to the value of the investments
NVCA COVID-19 Resources are available for more in-depth analysis on this matter.