This is the information we have as of April 13, 2020 and is our interpretation of the rules for applying for the Paycheck Protection Program (PPP).
The US CARES Act, passed on March 27, authorizes the Small Business Administration (SBA) to guarantee about $350 billion in loans under the SBA’s new Paycheck Protection Program (PPP) to businesses with fewer than 500 employees. However, those small businesses backed by private equity (PE) or venture capital (VC), may not be eligible because of the SBA’s ‘affiliation rules.’
The affiliation issue has to do with the calculation of the 500-employee maximum for eligibility and whether the investors’ other portfolio companies are included in that count.
What constitutes affiliation? Under the SBA guidelines, a VC or PE investor with a minority ownership interest is deemed to be affiliated if it has certain ‘blocking rights’ or control over day-to-day operations of the company. Put another way, does the start-up require investor approval to action how it operates?
Typically, VC and PE firms finance their investments in portfolio companies through preferred stock instruments. These instruments often provide ‘negative’ control rights, such as the ability to veto certain management decisions. In addition, investors often bargain for ‘protective provisions’ to safeguard their investments. These provisions are at the core of the affiliation issue.
Here are a couple of examples of the provisions that may establish affiliation:
- The protective provisions require the presence of an investor at board meetings to establish a quorum.
- Minority shareholder has the ability to prevent a quorum or otherwise block action by the board of directors or shareholders – known as negative control.
- The ability of an investor to block activities of the start-up for determining or amending such things as: payment of dividends, employee compensation, appointment or removal of senior executives, employee stock option or incentive programs, capital expenditure, lease or real estate requirements, incurring leverage (corporate borrowing), changing the company’s strategic direction, etc.
An analysis of the protective provisions of the start-up’s preferred stock will be necessary to determine whether preferred stockholders were given the rights to approve certain decisions made by or with respect to the company. The start-up and its counsel will also need to examine, among other things, its certificate of incorporation and bylaws.
If affiliation exists, what can be done to change it?
If it is determined that an affiliation exists, the SBA seems to have given its blessing to one ‘quick fix.’ The SBA provides that where a minority shareholder ‘irrevocably waives or relinquishes’ existing rights that trigger affiliate status, the underlying business may become eligible for a PPP loan, if those rights were waived before the start-up applied for the loan. Another solution may be to amend the start-up’s governing documents, removing blocking rights of day-to-day activities. This, of course, requires investor approval. And unsurprisingly some investors may be unwilling to oblige.
Political pressure is building to address the VC and PE affiliation issue. PE-backed businesses are clamoring for clarity and funds. There is no clear or simple solution to address this issue at this point – and no guarantees any changes you make will have a successful result.
The SBA guidelines that establish affiliation are complex and we recommend, among other things, conducting a thorough review of the agreements negotiated with investors to determine where you stand before taking any action.
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