Much has been written recently about the plight of small businesses backed by venture capital (“VC”) investors. Like other small businesses who haven’t raised capital in the VC community, they are impacted by the COVID-19 pandemic and resulting stay at home and shut down orders of our federal, state and local government officials. They are in the same position of making difficult decisions about employees, supply chains and customers, and many need a life-line to survive.
The CARES Act established a Payroll Protection Program for loans to small businesses, within the U.S. Small Business Administration’s Section 7(a) loan program. Designed to give critical support to small business companies with less than 500 employees, and enabling them to keep workers employed and maintaining their pay levels, PPP Loans are expected to be in high demand, and to run out quickly.
There is, perhaps, an unintended consequence of the way the PPP Loan eligibility standards were written in the CARES Act. The SBA’s affiliation rules for Section 7(a) loans require applicants to count employees of other companies whose businesses are “affiliated” with the applicant using a standard of control, including the power to control. This could take many deserving applicants, who have numbers of employees below 500 (or the larger number of employees for various industries, as provided in the SBA’s table of small business standards for a variety of industries) out of the eligibility pool for PPP Loans.
Apparently, House Minority Leader Kevin McCarthy (R–California) has been communicating with the U.S. Secretary of the Treasury Steven Mnuchin about the issue, and suggests the confusion about application of the SBA’s small business affiliation rules for PPP Loans is “going to be solved.” Much has been said about this problem by law firms and other service providers supporting the venture capital and private equity communities. This reminds me of a quote, often attributed to former NCAA Football Coach Lou Holtz: “When all is said and done, usually more is said than done.”
Keep reading, I have an idea. But first, let’s define the problem.
The SBA affiliation rules for Section 7(a) loans are found in 13 CFR Section 121.301. Section 301 describes “affiliation” for purposes of Section 7(a) financing based upon the concept of control. In its simplest form, according to Section 301, a stockholder (emphasis on “a” stockholder, not a group of stockholders) who owns or has the power to control more than 50% of the business’ voting equity “controls” the business, and is therefore affiliated. If that VC investor similarly controls other businesses, then all of the other business’ employees are counted in the loan applicant’s PPP Loan Application and, if the aggregate number exceeds 500, the applicant is ineligible for a PPP Loan. Control or the power to control a business, and therefore affiliation, may also be found where an investor controls a majority of the board of directors. If these two tests were the sole factors used in defining control for PPP Loans, this issue would not be terribly complicated. There are actually few businesses whose VC investors actually control more than 50% of their voting power; most of these VC backed companies would be eligible for PPP Loans.
But there is another complication. Control can be established for Section 7(a) loans by either “affirmative” or “negative” covenants and protective provisions. Affirmative control exists where a VC investor’s approval is required for the company to take certain actions. Negative control, on the other hand, is more nuanced and may be more challenging to VC investors, as well as SBA lenders, to detect. When a VC investor has the ability to block a variety of corporate actions, by creating a deadlock on the board of directors, by preventing a quorum at board or stockholder meetings, or by having control over voting decisions for business decisions involving day-to-day management decisions (distinguished from more fundamental, significant decisions, like mergers or sales of the business). This is the feature that brings SBA lenders participating in the PPP Loan Program to encourage venture-backed companies to talk with their lawyers before signing and filing that PPP Loan Application.
The National Venture Capital Association has written to the SBA and the Treasury Department urging them to include venture capital-backed startups in the PPP Loan Program. The NVCA has also issued detailed guidance on the question for its members, describing the types of operational controls that could potentially trigger the affiliation rule. According to the NVCA:
“Current OHA case law indicates that a minority investor’s control over or ability to block any of the following decisions or actions of a company, including through a director that is required to approve or holds a veto, will be held to create affiliation:
• Making, declaring, or paying distributions or dividends other than tax distributions.
• Establishing a quorum at a meeting of stockholders (and likely, by extension, at a meeting of the board).
• Approving or making changes to the company’s budget or approving capital expenditures outside the budget.
• Determining employee compensation.
• Hiring and firing officers and executives.
• Blocking changes in the company’s strategic direction.
• Establishing or amending an incentive or employee stock ownership plan.
• Incurring or guaranteeing debts or obligations.
• Initiating or defending a lawsuit.
• Entering into contracts or joint ventures.
• Amending or terminating leases.”
The NVCA goes on to suggest a solution to this control problem: “Armed with this analysis, it may be possible to amend governing documents to mitigate any control rights that are considered high risk for creating affiliation prior to submitting the SBA loan application.”
This may also be a sign of another application of the law of unintended consequences. It may very well be that no one actually intended to block a company’s participation in SBA financing programs, such as Section 7(a), when they included the laundry list of this that require the VC investor’s approval. It could be, candidly, that these are in the VC investor’s standard investment documents. Even the protective provisions in the popular and often used Series Seed Preferred Stock “standard” documents include (or are modified to include) protective provisions touching on some or all of the above corporate actions.
Distressed VC-backed companies have several other problems to solve and difficult decisions to make, with what is certain to be a brief window of opportunity to obtain PPP Loans, and considering alternative sources of capital may be few and far between for the foreseeable future. Right now, companies need to have the actual power and control to navigate troubled waters and make day-to-day management decisions that are necessary to keep the business running (and to protect the VC investor’s investment). Amendments to governing documents, after all, often require filings with the Secretary of State of the State in which the company is organized. As you may have guessed, the California Secretary of State has become severely backlogged in processing corporate filings, such as amendments to articles of incorporation. As of Monday, April 6, 2020, the California Secretary of State was processing corporate amendment filings submitted on March 11, 2020. If a corporate amendment filing were filed today, Monday, April 6, 2020, it could take several weeks, perhaps months, for the filing to be returned and confirmed by the Secretary of State. Expedited service options are available, of course, for significant additional fees. And to avoid risks of submitting false loan applications in the PPP Loan program, for those relying on amendments to agreements and governing documents to navigate application of the affiliation rules, applicants are generally expected to ensure those amendments are effective and valid upon submission.
In this author’s opinion, it should not be necessary to secure Federal intervention to solve this problem, particularly for VC-backed portfolio companies whose largest VC investors’ holdings are less than 50% and they do not control the company’s board of directors. In these scenarios, where voting or protective provisions and similar covenants in charter documents or investment documents are reasonably likely to be determined to be a basis for affiliation under the regulations applicable to Section 7(a), and the company would otherwise be eligible for a PPP Loan, how about just doing your portfolio companies a “solid”, and delivering a written consent approving any amendments or effectively waiving application of those covenants, restrictions, provisions or features of governing documents or investment documents which, according to the SBA’s published guidance or decisions of the SBA’s Office of Hearings and Appeals, may establish affiliation for purposes of the PPP Loan Program, for a period starting immediately (ie., prior to submission of the company’s PPP Loan Application), and continuing thereafter until the resulting PPP Loan is forgiven (meaning, the company used the proceeds for purposes permitted by the CARES Act), or the PPP Loan is repaid by the company in full (meaning, the SBA lender and the US government were made whole on their investment), or until the U.S. Treasury or SBA issues guidance and rulemaking addressing this issue. Doing so would be designed to enable the portfolio company to participate in the PPP Loan Program and to submit a Loan Application to an SBA Lender on much firmer ground considering the affiliation rules. PPP Loans under the CARES Act may not be available given high demand by small business concerns. Time, as always, is o the essence.
Distressed companies struggling to secure PPP Loans and looking for life-lines need certainty and predictability, and the VC investors who have invested in them are in an ideal position to deliver just that on this particular issue. If they are not willing to, then that might just be the kind of control to which the SBA affiliation rules were designed to apply.
Author: J. Michael Vaughn, Shareholder, Enterprise Counsel Group