Why is there so much confusion on whether venture capital-backed startups are eligible for SBA Section 7(a) loans under the Paycheck Protection Program (the PPP)? The confusion has largely stemmed from:
(1) the “Affiliation Rules,”
(2) widely shared misreading of which rule applied (see last week’s Forbes article on Section 301(f) vs. Section 103, which we’ll call the “Forbes Section 301(f) Article”), and
(3) the lack of clarity around protective provisions conferring control under the rules.
Let’s tackle these one at a time, starting with confirmatory guidance from the Treasury Department issued within the last 24 hours:
1) Affiliation Rules: Why it’s important that Section 301 (not 103) governs (see Forbes Section 301(f) Article)
I wrote about the “affiliation rules” in the Forbes Section 301(f) Article (citing the deeper analysis I had earlier co-authored with my Lowenstein Sandler LLP colleagues: Matthew J. Moisan, Ed Zimmerman, Lowell A. Citron, Kimberly E. Lomot, and Raymond P. Thek, “SBA Section 7(a) Loans for Venture Capital Backed Growth Companies/Startups Under the CARES Act,” Lowenstein Sandler LLP (March 31, 2020) (the “Lowenstein Sandler SBA Section 7(a) Paper”).
That analysis explained that because Section 301(f) governed, many startups would NOT be “affiliates” of their VCs. That’s important because eligibility for these SBA Section 7(a) loans hinges on (among other things) having 500 or fewer employees (remember, the “SB” in “SBA” is for “Small Business”) and if startups were “affiliates” of their VCs, the analysis would require startups to count all of their employees but also add in the employees of the VC and all of the VC’s other startups. That would make most (if not all) startups ineligible for SBA Section 7(a) loans. Because Section 301, however, governs “affiliate” analysis for SBA Section 7(a) loans, far fewer VC-backed startups will be swept into the “affiliate” trap.
CAVEAT: You kind of have to read the Forbes Section 301(f) Article and/or the Lowenstein Sandler SBA Section 7(a) Paper, because I’m not repeating all of that analysis here and you’ll miss some steps you have to take.
2) Spoiler: Treasury’s New Guidance Confirmed it’s Section 301
“However, the detailed affiliation standards contained in section 121.103 currently do not apply to PPP borrowers, because section 121.103(a)(8) provides that applicants in SBA’s Business Loan Programs (which include the PPP) are subject to the affiliation rule contained in 13 CFR 121.301.”
The above is from the Treasury’s detailed guidance last night (April 3), noting:
“This interim final rule supplements the Initial Rule with additional guidance regarding the application of certain affiliate rules applicable to SBA’s implementation of sections 1102 and 1106 of the Act and requests public comment.” (Emphasis added)
“Business Loan Program Temporary Changes; Paycheck Protection Program,” April 3, 2020, “Treasury April 3 Interim Final Rule”). That’s consistent with Treasury’s April 2, 2o2o guidance (“Interim Final Rule”) (eligibility includes “A small business concern as defined in section 3 of the Small Business Act (15 USC 632), and subject to SBA’s affiliation rules under 13 CFR 121.301(f) unless specifically waived in the Act”). See also, the explanation of the changes made that that Interim Final Rule, as published by my colleagues Lowell A. Citron, Michael A. Buxbaum, Theodore C. Sica, and Kimberly E. Lomot, “SBA Paycheck Protection Program Update: SBA Interim Final Rule,” Lowenstein Sandler LLP (April 3, 2020).
3) Protective Provisions
As outlined in the Forbes Section 301(f) Article, the analysis begins with determine whether any single stockholder has more than 50% of the startup’s equity (calculated per Section 301(f)) or the right to control a majority of the startup’s board. Even without a control stockholder, the Affiliate Rules still require determining whether any single VC controls significant protective provisions, enabling that VC to block meaningful corporate action and, if so, that VC may well control the startup.
While there’s caselaw on this, much of that case law (maybe all or almost all) focuses on Section 103 rather than Section 301(f), because Section 301(f) is newer. It appears that much of that caselaw also falls outside the context of venture capital backed startups. This makes sense because SBA loans have been scarcer among venture-backed startups. We plan to publish analysis of Section 103 “Negative Controls” or “Protective Provisions” caselaw, but let’s look at some of the differences in the two provisions and talk about how to approach them.
Protective Provisions Under Section 103 vs Section 301: The “Negative Control” or “Protective Provision” cases under Section 103 are POTENTIALLY distinguishable from the way the law would apply under Section 301 because Section 103(a)(3) is it’s own subsection (as opposed to the singular sentence in Section 301(f)(1)’s stock ownership provision, and Section 103 also adds: “includes but is not limited to,” which Section (301(f)(1) does NOT. Moreover, Section 103 is a rule already providing for a minority shareholder to share “control” with one or more other minority shareholder(s), while Section 301(f)(1) ONLY finds percentage ownership control when the holder exceeds 50% of the voting equity. Hence, Section 103(a)(3) should cast a wider net than Section 301(f)(1) in finding protective provision to confer “control” for determining who is an “affiliate.”
Here’s Section 103(a)(3):
“(3) Control may be affirmative or negative. Negative control includes, but is not limited to, instances where a minority shareholder 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.” (Emphasis added).
Here’s Section 301(f)(1) – last sentence:
“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.”
For the reasons discussed in the Forbes Section 301(f) Article, Section 103 empowers SBA to also “find 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.” That’s not the case with Section 301. Similarly — and this is more complicated — there’s “totality of circumstances” language in Section 103(a)(5) that provides SBA with a different toolkit to find control “even though no single factor is sufficient to constitute affiliation.”
Protective Provisions: Waive/Amend? If there’s a single equityholder (VC) who controls a veto, what’s the best way to waive/suspend/delete provisions that might be construed to confer control? The express language of Section 301(f) says that a shareholder agreement can confer power to control, therefore, it seems that a shareholder agreement should also be able to remove that power to control. Accordingly, the following elements of a shareholder agreement designed to eliminate control between a shareholder and the startup, should work. The written agreement should be:
- actually enforceable and lawful,
- not revocable by the investor — in other words, the startup would need to consent to a revocation or amendment to the agreement,
- in writing,
- effective from at least the minute before the application and certification are submitted by the startup until at least as long as the loan is outstanding (maybe longer, but that’s a debate we can have later), and
- in good faith, and therefore actually fully respected by the parties.
There are a number of situations in which a single stockholder “controls” a series of preferred stock because it holds more than 50% but less than all of that series. In those situations, that stockholder might by itself control a veto because the protective provisions in that series are based on a majority vote. In that situation, the startup and that stockholder could amend so that this particular stockholder can neither block alone nor green light alone the action covered by those protective provisions. In other words, one way to clear the protective provision hurdle is to waive the provisions, while another way to clear the hurdle would be to retain the protective provisions but make them shared provisions (rather than the right of a single stockholder).
Startups and VCs will need to ensure that they are in good faith being diligent, as the lenders will require the startup to sign a certification, which is a serious obligation/responsibility. In the light of day, good faith efforts to have complied will be important. It’s also the right thing to do.
 Note that the document is undated, but was tweeted by Treasury Secretary Steve Mnuchin (from his iPhone) at 7:15 p.m. on April 2. (“Guidance for the Paycheck Protection Program is live! We encourage lenders to visit https://home.treasury.gov/system/files/136/PPP—IFRN%20FINAL.pdf for more details.”). Treasury appears not to have tweeted it.
 Section 103(a)(5) states: “In determining whether affiliation exists, SBA will consider the totality of the circumstances, and may find affiliation even though no single factor is sufficient to constitute affiliation.”