The Association for Corporate Growth (ACG) recently sent a letter to U.S. Secretary of the Treasury Stephen Mnuchin and U.S. SBA Administrator Jovita Carranza, urging relief on this issue. In that letter, the ACG explained:
Current rules would force these companies [with private equity backers] to aggregate the employees of all of the unrelated companies in which their investors are affiliated and count them in their employee count, pushing many above the 500-employee threshold. Private equity firms and private family offices alike, have on average of a dozen companies in their portfolios. Under the current affiliation rules, all of these firms would be aggregated, pushing the total number of employees over the 500 mark in many instances, even though each startup is a separate entity. The current affiliation exemption in the CARES Act does not address this.
The ACG’s plea captures the issue nicely. And it is a somewhat politically sensitive one.
Under the SBA’s affiliation rules, there are four control-based affiliation tests that apply to participants in the PPP. These include tests for affiliation based on ownership; rights under stock options, convertible securities, and agreements to merge; management; and the existence of an identity of interest.
To get a little technical for a moment, in most cases the SBA’s affiliation rules under 13 C.F.R. section 121.301(f) provide the rules that govern the affiliation analysis. This has been a point of confusion among many commentators—many of whom have conflated “section 310(f)” with “section 301.” The detailed affiliation standards set out in section 121.103 do not generally apply to PPP borrowers. In point of fact, section 121.103(a)(8) kicks PPP applicants out from under the section 103 rules and into the rules under section 301, by providing that applicants in the SBA’s Business Loan Programs, which includes the PPP, are subject to the affiliation rules in section 301. (There are, however, some limited exceptions under the CARES Act.) Now how do these rules work?
Generally, the SBA treats entities as affiliates if one has the power to control the other. Affiliation can also exist where that control is exercised through a third party. The SBA’s regulations provide that control can be affirmative or negative. And it does not matter whether control is ever actually exercised. The mere ability to exercise control is enough.
Majority ownership is the easy example. If a VC firm owns more than 50% of the interest in a company, that fact—standing alone—creates an affiliated status. And, what is more, the portfolio company is also treated as being affiliated with any other business that is controlled by the VC firm—regardless of the basis for finding affiliation under the SBA’s rules. Again, majority ownership is the easy example. But what about where the VC or PE firm owns a minority stake? That is where things get more interesting—and complex.
A minority stakeholder can still have a level of control that gives rise to an affiliated status. The SBA regulations say that negative control is enough. “Negative” control may exist where a minority shareholder “has the ability, under the concern’s charter, by-laws, or shareholder’s agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders.” If a VC fund has a minority stake in a company but has the right to block the board of directors from taking certain day-to-day actions, the VC fund may be affiliated with the company under these rules. This type of right is common in VC and PE financing arrangements.
The SBA has interpreted this rule pretty broadly. In fact, under its precedent, negative control exists when a minority owner can block ordinary actions that are essential to day-to-day operations. Affiliation may exist where the company’s governing documents provide the VC fund with negative control over the company’s budget, the power to hire and fire officers, or the authority to set employee compensation. Likewise, the authority to control the borrowing of money, purchases of equipment, or even amendments to a lease can give rise to negative control.
The SBA may also find that affiliation exists if the CEO or president—or other officer—of a company controls another business. In fact, if an individual or entity controls a business through a management agreement, that may be sufficient to give rise to affiliation.
There are other factors to consider in the analysis as well. In determining a business’s size, the SBA engages in a bit of legal fiction. It treats stock options, convertible securities, and agreements to merge as though the rights granted by those instruments have actually been exercised. It then looks at the power to control. Things get complicated quickly where sophisticated investment relationships exist.
How Can VC- And PE-Backed Companies Address The Affiliation Conundrum?
Interestingly, the SBA seems to have given its blessing to one potential “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 business applied for the loan. So a VC fund that has the right to prevent a quorum or otherwise block action by a portfolio company’s board of directors can solve the affiliation problem by irrevocably waiving that right.
Another solution may be to amend the portfolio company’s governing documents. This, of course, requires investor consent. And some investors may be unwilling to oblige. But there may be substitute rights or limitations on other matters that could serve as alternatives in order to provide the investing VC fund with adequate protection in exchange for its consent. This route will inevitably depend upon the facts and circumstances. At any rate, amending the governing documents to eliminate the minority investor’s rights to control ordinary actions may be a solution for some companies if done properly and before applying for a PPP loan. More complex solutions may be available as well, depending on the facts and circumstances.
What Will The Future Hold?
Political pressure is building to address the VC- and PE-affiliation issue. PE-backed businesses are clamoring for clarity and funds. Their fate remains to be seen. As some in Congress are seeking additional PPP appropriations in light of the program’s surging demand, others are pushing back. In the midst of the push and pull, VC and PE-backed companies—and their employees—are waiting on edge.