Background: On March 27, 2020, the U.S. House of Representatives passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act (the CARES Act), which the President subsequently signed it into law. The CARES Act establishes a new type of loan program known as the Paycheck Protection Program (the program) within the U.S. Small Business Administration’s (SBA’s) 7(a) loan program. The program has several attractive features, including, most notably, forgiveness of a portion of the loan, provided that (i) the proceeds are used for payroll, rent, utilities, and other eligible expenses that are (ii) incurred during the eight-week period immediately following the origination of the loan.1 Other beneficial features include but are not limited to (i) a maximum interest charge of 4% (subject to adjustment when SBA issues regulations); (ii) deferred repayment of a minimum of six months and a maximum of one year of all principal, interest, and fees; and (iii) no required personal guarantee.2
For more information on specifics of how forgiveness of SBA 7(a) loans works, including how to calculate the amount forgiven, please see here. (Subsequent to originally publishing this, we also published a more plain language analysis in Forbes3).
Loan Amount: The maximum principal amount of the SBA 7(a) loan is generally based on a formula that is the lesser of (i) 2.5 times the applicant’s average monthly payroll costs incurred during the one-year period immediately preceding the date of the covered loan and (ii) $10 million (the limit on conventional SBA 7(a) loans is currently $5 million).
Eligibility: Generally speaking, a U.S.-based business operating for profit must fall below certain size or income/receipts limits to be eligible for an SBA Section 7(a) loan.4 For eligibility, the business cannot employ more than 500 employees (including full-time, part-time, and those employed on other bases).5 While the CARES Act does not specifically address SBA’s maximum receipt requirements, we expect SBA may impose eligibility limits based on receipts in accordance with SBA’s existing receipt requirements (please see the SBA sizing tool based on number of employees and receipts).6
Affiliates: In order to determine an applicant’s employee count, the program applies certain rules regarding control and affiliates. See 13 CFR §121.1037 (we refer to this as Section 103) and 13 CFR §121.3018 (we refer to this as Section 301). According to both Section 103 and Section 301, eligibility for these SBA 7(a) loans is governed by Section 301, NOT by Section 103. See Section 103(a)(8) and Section 301(f). The two Sections have similar language but differ in important ways and this has been a source of some confusion in the market. SBA's Small Business Compliance Guide (the SBA Guide) explain that these rules require business that are under common control to be counted together (i.e., all of their employees) or “aggregated” to determine eligibility for Section 7(a) loans. For instance, to determine eligibility of a wholly or majority-owned subsidiary SBA would "aggregate" (or add together) that subsidiary’s employees with all the employees of the parent company (and the other companies that parent “controls”). That "aggregration" could render all of those commonly controlled companies ineligible for SBA 7(a) loans.9 However, because the SBA Guide primarily focuses on Section 103 and not Section 301, the affiliation analysis requires extra care.10 While certain circumstances establishing control under Section 301 are clear, there are a few specific issues in which the regulations provide less certainty as to whether SBA would find “control” and therefore, affiliation. However, Section 301 is more friendly to venture-backed startups than Section 103 would be.
One very meaningful difference between Section 301 (governing Section 7(a) loans) and Section 103 is that Section 103(c)(2) finds affiliation where
“two or more persons … each owns, controls, or has the power to control less than 50 percent of a concern's voting stock, and such minority holdings are equal or approximately equal in size, and the aggregate of these minority holdings is large as compared with any other stock holding, SBA presumes that each such person controls or has the power to control”
In contrast, Section 301 does not have an analogue to this part of Section 103. Consequently, Section 301 analysis would NOT base “affiliation” on having two or more equityholders with roughly equal holdings who together are “large” compared to others. Instead, Section 301 will look to the power to “control” that is held by an equityholder (rather than a fragmented group of several unrelated minority holders). That's very relevant to venture capital-backed companies that might have three investors who together share a veto of a given set of corporate actions, but who alone cannot control the outcome.
In sum, Section 301 "affiliation" may arise in the following circumstances (this isn't an exhaustive list, but does reference those items in Section 301 most pertinent to venture-backed startups and growth companies):
- Affiliation based on ownership–any person that owns or has control of more than 50% of the voting equity is deemed an affiliate (this is an irrefutable presumption).
- Affiliation Based on Negative Controls--“SBA 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 shareholder’s agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders."
- Affiliation based on convertible/exercisable securities–SBA considers any convertible securities on an as-converted/as-exercised basis when determining control. However, SBA will not count convertible securities when conversion depends on a condition that is “incapable of fulfillment, speculative," or "unenforceable under" law.
- Affiliation based on management–affiliation may arise where a President or CEO controls two entities.
Guidance: Most startups and growth companies will find it relatively straightforward to determine whether an equityholder controls or has the power to control more than 50% the voting equity, or to designate a majority of the board of directors. Similarly, it should be straightforward to understand whether a President or CEO controls multiple entities. The analysis of protective provisions has, however, been cause for some concern as many in the venture community have asserted that protective provisions would likely confer control on a group of minority holders. Our read is that this will only be true where an investor is a minority investor who had an individual veto right/block. Even in that situation, understanding the subject matter covered by that veto will be important as the law seems to focus on finding control where the veto covers day-to-day management of the company rather than extraordinary items. So, for instance, SBA would not deem control arising solely from a veto over a sale or the conversion of that holder’s preferred stock into common stock. That’s an important distinction between Section 103 (above) and Section 301 (which governs these Section 7(a) loans). So, if the startup or growth company has neither a majority equityholder nor any investor/equityholder with an individual veto right, it would be difficult to see how Section 301 analysis would find “affiliates.”
Accordingly, while some venture-backed companies will be ineligible for the program, we believe that a good number of venture-backed startups and growth companies should be eligible. More specifically, the law itself together with its legislative history indicate that a large ownership stake or control over day-to-day management are at the heart of SBA Section 7(a) loan "affiliate" analysis. While certain negative controls or negative covenants may give rise to an affiliate relationship, many will not. Section 301 does not cast as wide a net of “affiliation” as Section 103 does. We have further thoughts on how to approach individual equityholder veto rights as well to ensure that you remain in compliance with and eligible for Section 7(a) loans. In sum, we believe that many venture-backed and growth companies will be eligible under the program.
In light of the foregoing and the heightened demand SBA lenders are confronting, we encourage potential borrowers to contact their SBA lender as soon as possible to help determine eligibility. As always, we are here to continue to support the venture, startup, and growth communities and encourage you to contact us if you have any questions or comments.
To see our prior alerts and other material related to the pandemic, please visit the Coronavirus/COVID-19: Facts, Insights & Resources page of our website by clicking here.
1 Lowell A. Citron, Michael A. “Bux” Buxbaum, Theodore C. Sica, and Kimberly E. Lomot, “SBA Paycheck Protection Program,” Lowenstein Sandler LLP (March 29, 2020) (hereafter, “LS SBA PPP Article”)
3 Ed Zimmerman, “Venture-Backed Startups Can Access SBA 7(a) Loans – What The Experts Aren’t Telling You!,” Forbes (April 1, 2020).
4 SBA Small Business Compliance Guide: Size and Affiliation, June 2018.
5 SBA has provided different limits in certain specific industries, such as NAICS Code 72, franchises and certain businesses receiving financial assistance from a company licensed under Section 301 of the Small Business Investment Act of 1958. See LS SBA PPP Article.
6 See 13 CFR §121.201. Again, these may vary based on the specific industry in which the business operates.
7 See 13 CFR §121.103(a)(8) (“For applicants in SBA’s Business Loan, Disaster Loan, and Surety Bond Guarantee Programs, the size standards and bases for affiliation are set forth in §121.301.”); and 13 CFR §121.301(f)
(“Affiliation under any of the circumstances described below is sufficient to establish affiliation for applicants for SBA’s Business Loan. ... For this rule, the Business Loan Programs consist of the 7(a) Loan Program …”).
8 See, SBA Guide at pp. 3-4 (“For the SBA’s Business Loan, Disaster Loan, and Surety Bond programs, the affiliation regulation can be found at 13 C.F.R. § 121.301(f). The Business Loan programs consist of the 7(a) Loan program … Differences in the treatment of affiliation in these programs are noted below.”). The SBA Guide does not fully detail the differences between Section 301 and Section 103.
9 SBA Small Business Compliance Guide: Size and Affiliation, June 2018.
10 See SBA Guide at pp. 3-4 (“For the SBA’s Business Loan, Disaster Loan, and Surety Bond programs, the affiliation regulation can be found at 13 C.F.R. § 121.301(f). The Business Loan programs consist of the 7(a) Loan program. … Differences in the treatment of affiliation in these programs are noted below.”). The SBA Guide does not fully detail the differences between Section 301 and Section 103.