Companies with venture capital, private equity or other entity investors may encounter problems when applying for a Paycheck Protection Program (“PPP”) loan under the CARES Act because of the SBA’s definition of “affiliate.” If an investor has a majority position in a company, it will generally be classified as an affiliate of that company. Even if such investor has a minority ownership position, however, the inclusion of certain corporate governance and control provisions in the deal documents or other factors may cause the company to fail to qualify for a PPP loan due to the investor’s classification as an affiliate of the company.
The PPP generally requires companies (subject to limited exceptions) to have 500 or fewer employees in order to be eligible to participate in the program. The problem that arises here for VC- and PE-backed companies is that SBA rules may consider the VC or PE investor to be an “affiliate” of the company if such investor has control over certain of the company’s actions. Unfortunately, most VC or PE deals grant the investor a number of control rights over corporate governance, operational and other items. The SBA may determine that the presence of these rights makes the investor an “affiliate” of the company, and thus the investor’s total number of employees (possibly including employees of all of the investor’s portfolio companies) may have to be included in the number of employees of the company. This may cause the company to exceed the 500-employee limit and thus be ineligible to receive a PPP loan. It appears that this may be a problem for a large percentage of the VC- and PE-backed companies that may seek financing under the PPP.
All companies in this position should clearly resolve this affiliation issue up front before filing the PPP loan application. Obtaining PPP financing is a tremendous positive opportunity for most companies, and you need to make sure that you have resolved the affiliation issue so that it doesn’t cause your loan application to be denied. Additionally, if your company does receive a PPP loan and a subsequent review or audit shows that an affiliation problem existed at the time of the loan, your company could face negative consequences, including potential enforcement action. We believe that even though the SBA is trying very hard to be accommodating and is facilitating the loan process now, given the tremendous amount of funds involved there will likely be oversight and potential enforcement activity later.
There may be a solution to this problem, however, as not all of an investor’s veto or control rights will create an affiliate relationship with the borrower. Broadly speaking, an investor’s rights which result in the investor’s control over the company’s daily business operations may create an affiliate relationship. Other types of rights, which are deemed to be outside of the normal daily course of the company’s business, may not create an affiliate relationship. Examples of control rights which affect daily business operations and thus may create an affiliate relationship are hiring and firing of executives and officers, declaring and paying dividends, incurring or guaranteeing debt, initiating or defending litigation and fixing employee compensation. Example of control rights which are outside of daily operations and which may not create an affiliate relationship are engaging in a merger, sale of assets or similar transaction, filing bankruptcy, issuing equity and encumbering the company’s assets.
A problem here is that these lists of control items are not conclusive or absolute and cannot guarantee the absence or presence of an affiliate relationship with the company’s investor. There are also other items that may cause an affiliate relationship to arise. For example, if the investor has options, warrants or convertible securities that allow them to obtain control of the company, an affiliate relationship may exist. We strongly recommend that any company that is facing these issues should conduct an exhaustive analysis of the facts of its specific situation and consult its legal advisers before proceeding with the PPP loan process.
So, what’s a company to do if it determines that it may have an affiliation issue with its investor and that issue may imperil the company’s ability to obtain a PPP loan? One alternative here may be to work with the investor to amend the applicable deal documents to remove or soften the problem provisions. This may allow the company to avoid the affiliate problem and access the PPP funds. This will, of course, require some discussions with the investor since the company will be asking the investor to remove rights that are customary and that were bargained for in the original deal. This is a valid concern on the investor’s part, but the key here should be the potentially very positive effect of the PPP loan funds and the possibility that such a loan will be forgiven.
Please also note the the SBA has recently approved several Fintech companies as lenders under the PPP (e.g., Square, PayPal and Intuit). These companies may provide good alternative sources of PPP funds. Additionally, the Federal Reserve Board recently enacted certain Main Street Loan Facilities which provide significant additional loan funds for companies. These Main Street Loan Facilities increase the levels of certain qualification requirements associated with loan funds over the PPP requirements and thus may be helpful to larger companies.
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This publication is for general information only. It is not legal advice, and legal counsel should be contacted before any action is taken that might be influenced by this publication.
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