Takeaways

Companies that have investments from venture capital (VC) and/or private equity (PE) funds, or that have raised funds under similar terms from corporate investors, and that are economically impacted by the COVID-19 pandemic, may be able to avail themselves of small business loan opportunities and the Paycheck Protection Program.
Although new guidance and regulations implementing the Paycheck Protection Program are forthcoming, existing Small Business Association (SBA) regulations and precedents of its Office of Hearings and Appeals would pose particular challenges to companies that have investments with relatively common VC/PE protections.
The Act broadly amends the SBA’s definition of “small business” to include all companies that have 500 employees or fewer across all “affiliates,” but under existing SBA regulations, companies with minority investments from VCs, PEs, or corporate investors could be deemed to be “affiliated” with such minority investors, merely by virtue of standard protective provisions for such deals.

The Coronavirus Aid, Relief, and Economic Security Act (CARES Act), passed on March 27, 2020, sets aside $349 billion for Paycheck Protection Loans, which are available through banks, credit unions and other lenders (and guaranteed by the Government) and allows for forgiveness of certain amounts. The authority to make and approve loans under the programs is to be delegated by the SBA to participating lenders. (We summarized the Act’s small business loan provisions here.) Loans under the Paycheck Protection Program are available through June 30, 2020, and expanded Economic Injury Disaster Loans are available through December 31, 2020.

Eligibility Under a 500-Employee Size Standard

Any business operational as of February 15, 2020, with no more than 500 employees (unless the company’s primary industry classification code, available here, allows for a greater number of employees) is eligible to apply for Paycheck Protection loans under Section 7(a) of the Small Business Act. Businesses with no more than 500 employees also are eligible to apply for Economic Injury Disaster Loans provided under Section 7(b) of the Small Business Act. “Employees” include all individuals employed by the business and by the business’s domestic and foreign affiliates on a full-time, part-time or “other” basis.

With respect to its Paycheck Protection loans, the Act contains exceptions for three types of businesses: (1) industry “Sector 72,” which applies to Accommodation and Food Services—e.g., hotel and restaurant chains—such that businesses within this sector qualify for new loans as long as they do not have more than 500 employees at any given location; (2) franchises that are approved on the SBA’s Franchise Directory (which includes many well-known franchises); and (3) small businesses that receive financing through the Small Business Investment Company program. In other words, except with regard to these three categories, the Act still applies SBA affiliation rules.

The Act’s general application of SBA’s affiliation rules must be carefully scrutinized by companies with VC/PE and/or corporate investments that seek economic relief through the Paycheck Protection Program, as well as by their investors. Under SBA regulations, businesses are affiliated when “one controls or has the power to control the other.” 13 C.F.R. § 121.301(f).1 Preferred Stock financing instruments, of the sort conventionally used for VC, PE and corporate investments, impose standard protective provisions in connection with preferred stock investments. However, many of these routine provisions have been found to create affirmative or negative controls under the SBA regulations that may give rise to affiliation.

To the extent that an investor is deemed under SBA’s affiliation rules to control a portfolio company, the investor itself, and all its affiliates, including such other portfolio companies as it is deemed to control, would all be affiliated for purposes of the SBA regulations. In that event, size eligibility is measured by aggregating the employees of all the affiliated entities to determine whether an entity meets the 500-employee size standard (for most industries). Anticipating this concern, the National Venture Capital Association drafted a letter to the Secretary of the Treasury and the SBA Administrator dated March 27, 2020, that advocates for an interpretation of “affiliation” under the Act that will not render struggling portfolio companies ineligible for Paycheck Protection loans.

Pending revised guidance from the SBA or amendments to the Act by Congress that clarify the application of the SBA’s affiliation rules to participants in the Payroll Protection Program, portfolio companies and their investors should review and potentially revisit their current governance and business arrangements carefully to assess their eligibility for SBA loans under the Act. There can be serious consequences for a portfolio company that applies for and receives a loan under the Act if the Government later finds that the applicant misrepresented its size because it did not account for its affiliation with other entities.

With this background in mind, we highlight the important affiliation considerations below. Please note that these considerations are based upon the relatively new rules found in 13 C.F.R. § 121.301, as well as relevant OHA precedent interpreting the longstanding rules set forth in 13 C.F.R. § 121.103.

Affiliation Under SBA Regulations

1. Ownership. A clear-cut case of affiliation exists where an individual, fund or company owns, or has the power to control, 50 percent or more of another company’s voting stock. If no individual or company is found to control, SBA will deem the Board of Directors or President or CEO (or other officers, managing members, or partners who control the management of the concern) to be in control of the concern.

2. Negative Control by a Minority Shareholder. SBA also will deem a minority shareholder to be in control if that individual or entity has the ability, under the concern’s charter, by-laws or any shareholders’ agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders or controls the management of the applicant concern through a management agreement. While there is little case law interpreting the “negative control” provisions of 13 C.F.R. §121.301(f),2 a similar provision of 13 C.F.R. §121.103(a)(3) has been interpreted by SBA in connection with the types of protective provisions that are prevalent in preferred stock financings.

In general, SBA does not find a minority shareholder to control a company where the minority shareholder possesses only the authority to block—for example through veto rights or supermajority requirements—“extraordinary actions.” The SBA has found, in past small business size appeals applying 13 C.F.R. §121.103, that the following were “extraordinary actions” for which approval rights did not constitute negative controls giving rise to affiliation:

a. Dissolving the company.

b. Filing for bankruptcy.

c. Issuing additional capital stock.

d. Entering into a substantially different business than the company’s current business.

e. Selling substantially all of the company’s assets.

f. Mortgaging substantially all of the company’s assets.

g. Changing the size of the Board.

h. Admitting new members.

i. Amending the operating agreement in a way that materially changes the members’ rights.

j. Committing an act that would make it impossible to carry on ordinary business.

Where, however, the minority shareholder can block actions deemed “essential to the daily operation of the company,” such negative controls give rise to affiliation. Various OHA rulings have found the following among such problematic negative controls:

a. Control of the payment of dividends.

b. Control over the budget.

c. Power to hire and fire officers.

d. Authority to set employee compensation (including officers).

e. Control over the incurrence of debt.

f. Control over operating budgets, equipment purchases and the right to veto expenses over a certain dollar threshold.

g. Control over leases and encumbering assets.

These types of protective provisions, however, are common in preferred stock financings, and investments often are contingent upon them. A close review of the portfolio company’s investor agreements and governance instruments will be required to determine whether these covenants concern “extraordinary actions” or are “essential to the daily operation of the company.” Portfolio companies and their investors also should consider whether multiple minority investors, acting in concert, may collectively be deemed to “control” certain portfolio companies.

3. Stock Options, Convertible Securities, Agreements to Merge. SBA considers stock options, convertible securities, and agreements to merge (including agreements in principle) to have present effect on the power to control a company. SBA treats such options, convertible securities, and agreements as though the rights granted have been exercised—e.g., SBA gives them “present effect.”

4. Common Management. Affiliation may arise where the CEO or President of the applicant company (or other officers, managing members, or partners who controls the management or Board of the company) also controls the management or Board of one or more other companies, particularly where they have a concurrent engagement/employment with a minority investor.

5. Identity of Interest. Affiliation may arise where companies share identical or substantially identical business or economic interests, such where the businesses are controlled by nuclear family members.

In sum, SBA’s affiliation rules can be complex and may necessitate a thorough review of the precise terms of investment between one business and another. We advise investors and their portfolio companies to carefully consider the implications of the CARES Act’s non-waiver of SBA’s affiliation before seeking a loan or loan guarantee from the Government.

Additional Resources

Pillsbury attorneys can help clients interpret and assess the foregoing requirements as clients assess and strategize regarding the availability of SBA loan. Section 1114 of the Act directs the SBA to pass regulations to implement the Act by April 11, 2020. We are proactively monitoring the forthcoming regulations.


Pillsbury’s experienced crisis management professionals are closely monitoring the global threat of COVID-19, drawing on the firm’s capabilities in supply chain management, insurance law, cybersecurity, employment law, corporate law and other areas to provide critical guidance to clients in an urgent and quickly evolving situation. For more thought leadership on this rapidly developing topic, please visit our COVID-19 (Coronavirus) Resource Center.

1 Although the CARES Act refers to the affiliation rules of 13 C.F.R. § 121.103, we believe that reference to be in error, as the SBA regulations found in 13 C.F.R. § 121.301, which were adopted in 2016, expressly apply to loans under Section 7(a) of the Small Business Act. SBA may clarify this discrepancy when it issues its forthcoming regulations in response to the Act.

2 Note that, unlike 13 C.F.R. §121.103(a), 13 C.F.R. §121.301(f) does not make express reference to “negative” controls, although it does describe the concept.

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