The centerpiece of the coronavirus stimulus package, the Paycheck Protection Program (PPP) provides forgivable loans to small businesses to help them maintain their payroll. The program’s original appropriation of $349 billion was quickly spent; $172 billion of the second tranche approved by the latest stimulus bill has since been allocated. (That means roughly $138 billion remains available for loans – the new deadline is August 8). Yet one of the key questions facing many startup businesses is whether the Small Business Administration’s rules disqualify some small businesses that have venture capital funding.
What Is the PPP?
The Paycheck Protection Program (PPP) is a key feature of the Coronavirus Aid, Relief, and Economic Security Act (CARES) Act, better known as the government stimulus program.
This section of the stimulus package created a $349 billion fund in forgivable loans to small businesses. Funding was just increased with an additional $310 billion. The loans can be used to cover eight weeks of payroll expenses, as well as certain qualifying costs of overhead. (Note: Readers may also see PPP loans referred to as the new SBA 7(a) loans. This refers to the SBA’s loan guarantee program, which has been now updated to include the Paycheck Protection Program.)
Under the CARES Act, a qualifying small business will have its PPP debt forgiven so long as the business spends the money primarily on payroll and the rest on authorized costs. At least 60% of the forgiven amount must be spent on payroll, and the business must maintain both staffing levels and rates of pay. (A small business that lays off people or cuts pay will have their debt forgiveness reduced unless they reinstate employees and pay by December 31, 2020.)
The PPP is a sweeping measure designed to subsidize business payrolls, encouraging them to retain workers in anticipation of a recovery – and keep them off the ballooning unemployment rolls.
Why VC-Backed Startups Are Concerned
In the wake of the CARES Act, small businesses – defined as 500 employees or fewer – and their lawyers and accountants have worked to figure out exactly who qualifies for government aid. The SBA’s affiliation rule has raised particular questions on this issue.
This rule judges a business as small based on the number of people employed by both it and “affiliated” companies. The purpose is to prevent subsidiaries and branch offices of major corporations from taking advantage of a program designed to help small businesses, nonprofit organizations and neighborhood restaurants. However, many startup companies have asked if they qualify as affiliates of the venture capital or private equity firms that invested in them. Since these firms typically invest in many businesses at a time, defining startups as affiliated with their investors has the potential to push them beyond the 500-employee limit. Under this interpretation, many of these startups would be disqualified from small business relief under the PPP, as provided by the CARES Act.
What Is the Affiliation Rule?
The SBA defines a small business as one with 500 employees or fewer. The CARES Act extends this definition to the PPP:
“Small businesses with 500 or fewer employees – including nonprofits, veterans organizations, tribal concerns, self-employed individuals, sole proprietorships, and independent contractors – are eligible. Businesses with more than 500 employees are eligible in certain industries, which is one of the features that make the PPP different from other SBA loans.”
However, seeing whether you qualify is not a simple matter of taking a head count of the people working in your office. The SBA applies what is known as the “affiliation rule” to calculate how many employees work for a given business. It says that if a small business is controlled by another entity – for instance, a parent company – then the controlling entity and all of its affiliates could count as a single enterprise.
Ordinarily the SBA says affiliation applies “when one business controls or has the power to control another or when a third party (or parties) controls or has the power to control both businesses” and control “may arise through ownership, management, or other relationships or interactions between the parties.” The SBA makes this judgment based on the totality of circumstances. Control can apply positively (the controlling company can tell its affiliate what to do) or negatively (the controlling company has veto power).
Real estate creates the classic example of affiliation. It’s common for management companies to split every property they own into its own company, typically an LLC. The central management group will then be another LLC separate from, but in charge of, all the rest. Under this structure a real estate empire can oversee and control thousands of employees at properties spread all across the world, even though each of those properties will technically be a company that only employs a dozen people.
The SBA doesn’t want that group taking advantage of programs designed to encourage small businesses.
Does Affiliation Apply to PPP Loans?
For some small businesses, administering the Paycheck Protection Program through the SBA has created an urgent issue. If your business has received funding from a private equity or venture capital firm, does this create a controlling relationship under the affiliation test?
If so, this would create a situation very similar to our landlord example above. The SBA would consider every individual business in which the firm invested part of a general network of businesses, disqualifying all of them from these small business loans.
Startup companies, however, have argued that this in no way represents the actual nature of their investor relationship. Most businesses with large investors operate independently, and they don’t become an operational franchise of the investing firm. They are an investment that will pay off based on the work of others.
On April 3, 2020, the Treasury released a narrower definition of affiliation for the PPP program.
It Depends on Four Affiliation Tests
According to the newly modified rules, the four affiliation tests are based on:
- Equity ownership – a business is an affiliate of another entity if that entity owns or has the power to control more than 50 percent of the business’s voting equity.
- Stock options, convertible securities and agreements to merge – generally, the SBA will treat options, convertible securities and agreements as though the rights granted have been exercised, which may have a present effect on the power to
control a business.
- Management – generally, a business is an affiliate if the CEO, president, other officers, managing members or managing partners of the applicant business also control the management of one or more other concerns. Or if the person or entity who controls the board of directors or management of the business also controls the board of directors or management of one or more other concerns.
- Identity of interest – generally, there is an affiliation when there is an identity of
interest between close relatives, as defined in 13 CFR 120.10, with identical or substantially identical business or economic interests.
For a startup company with private equity or venture capital investors, affiliation will generally be based on the first test, stock ownership. The investing firm will own a portion of your business. If it owns or controls at least 50% of the voting shares of your business, then the investing firm controls the business for the purposes of affiliation.
The big question, though, was what if no single investor controls a majority share of the business’ stock, but several investing firms, combined, do? Would affiliation arise in this situation?
According to SBA guidance, the answer is no. So long as no single investment firm controls a majority of shares, startup firms are considered independent of their investors.
Why Non-Affiliate Startups May Still Be Ineligible
Though you pass the affiliation test, you may still be ineligible for a PPP loan. This is because the SBA released guidance that seeks to ensure that small companies that really need the money can get it.
Specifically, the SBA emphasizes that to get a PPP loan, companies must certify that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the [a]pplicant.” The SBA has interpreted this to mean that companies should not have access to other sources of liquidity, which rules out most publicly traded companies. It may also disqualify startups that have sufficient cash on hand or can get needed funding from their backers.
Companies that receive loans larger than $2 million will be audited, Treasury Secretary Steven Mnuchin announced more than three weeks into the program. They will have to substantiate their certifications that they needed the loans before they can receive any debt forgiveness. (Borrowers who think the new guidance may disqualify them from debt forgiveness had until May 18 to return their loans penalty-free.)
The new guidelines also specifically ban hedge funds and equity firms.
What Non-Affiliate Startups Should Do
Of course, you should begin working with your board. You’ll need its approval before moving forward.
Even if you can certify that you need the PPP loan to stay afloat, your board may not green-light your applying for one. This may be out of concern that another new ruling will disqualify you (the one about liquidity access came out three weeks after the program opened.) Other boards may want to avoid any bad optics – and so backers may offer to assist their portfolio companies if needed.
If you decide to apply for a loan, be absolutely clear about your investor relationships to the bank. It may have a stricter interpretation of the rules. If your bank is not an SBA-approved lender, you can use the SBA’s tool to search for eligible lenders in your area. You can also check out our list of participating banks and their requirements.
Tips for Small Business Owners
- Many financial advisors specialize in working with business owners. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- Learn about other programs that can help struggling small businesses. Some of these programs are grants, some are debt relief and some are loans.
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