“Dear Ed:
I’m panicking – I’ve been reading guidance published by industry experts – they all seem to agree that venture-backed startups like my company aren’t eligible for the new SBA 7(a) loans because I’m somehow an “affiliate” of my VCs and all of their other startups. I don’t even know what that means, and I really need the $$ now to keep our startup afloat. Help!
Sasha Startup”
Before I go on – there is no actual Sasha Startup. However, Sasha is an amalgam of countless emails, texts and calls my law firm colleagues (see disclosure) and I have fielded over the last week.I’m happy to be the bearer of GOOD news in this regard. Please read on to clear up confusion about venture-backed startups being somehow almost entirely shut out of the new SBA Section 7(a) loans. Spoiler alert – they’re not! (Link to longer footnoted column my colleagues and I published earlier this week).
The CARES Act (March 27, 2020) established a new type of loan program known as the Paycheck Protection Program (the PPP) within the U.S. Small Business Administration’s (SBA’s) Section 7(a) loan program.The startup/VC community read SBA’s arcane rules about “affiliates” and concluded that pretty much every startup would be ineligible because, as one observer said (paraphrasing):
‘most lawyers I spoke to read the affiliate provision in the CARES Act to mean that any venture capital-backed startup would need to affiliate with all the other startups in that VC’s portfolio.’
If this were correct (it isn’t) it would pose a problem: most companies which (together with their “affiliates”) have more than 500 employees are ineligible for SBA Section 7(a) loans. So, the question is, when do the “affiliate” rules force you to “aggregate” with your VC’s other portfolio companies (and the VCs themselves) for purposes of determining whether you have 500 employees?
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There are two different rules that explain how to determine whether SBA views companies as “affiliates.”
The early guidance focused on the wrong rule.
The wrong rule is 13 CFR §121.103. It’s a widely applicable rule, but it’s not the rule that governs Section 7(a) loans.
The rule that governs SBA Section 7(a) loans is actually 13 CFR §121.301. I have dyslexia (for real), so I hate that there’s a Section 301 and a Section 103 that both define “affiliate” for SBA programs.
Applying Section 301 rather than 103, however, matters a ton!
Section 103(c)(2) (the WRONG section) finds affiliation where multiple VCs each own sizable chunks of a startup’s stock and together “control” that startup, even if none of them owns a majority. In these cases, SBA will “presume” that each VC “controls or has the power to control” if:
“two or more persons [VCs] … each owns, controls, or has the power to control less than 50 percent…, 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…”
In contrast, Section 301 – (the RIGHT section), which actually governs SBA 7(a) loans – doesn’t have an analogue to this part of Section 103. So, for Section 7(a) loans, startups do NOT have to find “affiliation” based on having two or more stockholders with roughly equal holdings who together are “large” compared to others. Instead, Section 301 looks to the power to “control” that is held by an equityholder (rather than a group of unrelated minority holders) where that holder “owns or has the power to control more than 50 percent of the [company’s] voting equity.” That’s a really big difference, and very few VCs own more than 50% of a startup (typically, a VC fund owns a minority, not a majority, stake in a startup).
The analysis doesn’t end there. Both Sections 103 and 301 also note that there are controls enabling a stockholder to block corporate actions (in other words, the protective provisions or veto rights in venture deals) that could trigger a finding of “control,” resulting in SBA concluding that the VC is an “affiliate.”
The bottom line: Answer these three questions to help determine your VC-backed startup’s eligibility:
(1) does your VC hold 50% or more of your startup’s equity (calculated per Section 301(f)); or
(2) even absent that, does any single VC control a majority of the startup’s board; or
(3) even absent that, does any single VC control significant protective provisions, enabling that VC to block meaningful corporate action so that the VC controls the startup?
If you answer yes to ANY one of the above questions, seek guidance from counsel, because you may then need to add together your employee headcount with that of your VC and all of that VC’s other “affiliates.”
If you answered no, to all three questions, that’s likely good news (still talk to counsel). Many U.S.-based startups WILL qualify for SBA Section 7(a) loans, despite the negative early guidance announced on this topic.
There’s more detail available in the longer, nerdier, footnoted article my colleagues (Matthew Moisan, Kimberly E. Lomot, Lowell A. Citron, Ray Thek) and I co-authored.
Please – if your business needs cash, and so many do right now — find an SBA lender (here is a link to the SBA list of the 100 most active (7a) Lenders), and apply!
Good luck and stay healthy.
PS: The SBA didn’t change the laws in the last few days. Both Sections 103 and 301, as written well before the pandemic, say that Section 301 governs “affiliate” and “control” determinations for SBA Section 7(a) Loans.
DISCLOSURE: I’m a partner at the law firmLowenstein Sandler LLP. While we serve as counsel to many startups, growth companies and funds, this column is NOT intended to be legal advice, so do speak with your counsel. Also, this column is NOT intended to encourage applicants to complete the application in any way that is untruthful/inaccurate.
Resources/Notes:
ByMatthew J. Moisan,Ed Zimmerman,Lowell A. Citron,Kimberly E. Lomot, andRaymond P. Thek, “SBA Section 7(a) Loans for Venture Capital Backed Growth Companies/Startups Under the CARES Act,” Lowenstein Sandler LLP (March 31, 2020).
Lowell A. Citron,Michael A. “Bux” Buxbaum,Theodore C. Sica, andKimberly E. Lomot, “SBA Paycheck Protection Program,” Lowenstein Sandler LLP (March 29, 2020).
For those who want to see that this was already hard wired into the law: 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 circ*mstances 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 …”). See also, SBA Small Business Compliance Guide: Size and Affiliation, June 2018 (“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.
