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April 4th, 2020
CARES Act: Calculating Employee Headcount Under SBA “Affiliation Rules”
The recently passed Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) created a program called the Paycheck Protection Program (the “PPP”), which makes certain loans available to small businesses. Generally, a business may be eligible for a PPP loan if such business, together with its affiliates, has fewer than 500 employees, as determined under rules established by the U.S. Small Business Administration (the “SBA”), which administers the PPP(1). On April 3rd, the SBA issued the latest in a series of guidances (the “April 3rd Guidance”)(2) explaining its interpretation of the affiliation rules for purposes of the PPP and an updated application form(3), giving clarity to many potential loan recipients but disappointing others, particularly those with relationships with venture capital and private equity investors.
Prior to the issuance of the April 3rd Guidance, great uncertainty existed among potential PPP applicants as to how the SBA would determine “affiliation” for the purposes of determining an applicant’s headcount. The SBA regulations that preceded the adoption of the CARES Act provided for varying, and at times confusing, standards for determining affiliation, particularly in the context of applicants who had venture capital, private equity or other institutional investors with significant ownership interests and/or control rights (including negative control rights), even in the absence of majority ownership. In the April 3rd Guidance, the SBA confirmed that it would apply the standards codified in 13 CFR § 121.301(f) rather than § 121.103. That provision sets forth four tests of affiliation between applicants and certain other persons or entities that would be applied by the SBA under the PPP, satisfaction of any of which is sufficient to find affiliation and require aggregation of the applicant’s employees with the employees of such entity for determining the applicant’s number of employees. The test that has proven the most controversial is the “Affiliation based on ownership” test, which extends beyond simple ownership. In addition to including an entity or person that “owns or has the power to control more than 50 percent of the [applicant’s] voting equity, the “ownership” test also provides that the SBA will deem a minority owner of an applicant to be “in control” if that owner “has the ability, under the [applicant’s] charter, by-laws, or shareholder's agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders.” While the April 3rd Directive has provided more certainty to potential applicants in terms of the standard that would apply, some potential applicants were disappointed that a narrower test for affiliation was not adopted. In particular, the consideration of blocking rights may operate to exclude many small businesses that are backed by venture capital funds or other institutional investors because control rights are commonly found in the investment agreements that venture-backed companies negotiate with their investors. That said, the actual blocking rights granted must be closely examined. The SBA is more concerned with blocking rights over operational matters (such as budget approval, hiring/firing and compensation of employees and declaring distributions) than major corporate actions such as sale or liquidation. Some companies and their investors may wish to modify these rights in order to be able to avail themselves of the PPP loans.
Other factors are also relevant to the SBA’s affiliation test, including whether entities share common management or economic interests. For example, multiple companies sharing the same chief executive officer, or officers and managers, can be considered “affiliated” under the affiliation test. In addition, businesses controlled by close relatives with substantially similar business interests can also be deemed to be “affiliated”.
Investor-backed companies considering applying for PPP loans should carefully consider whether they would be deemed affiliates with their investors and their investors’ other portfolio companies or other entities under common management and thus need to aggregate their employee headcount for purposes of determining eligibility under the PPP. Some such companies are asking their investors to consider modifying or waiving any blocking rights that may give rise to a determination of “control”.
(1)Some businesses with more than 500 employees may be eligible if the company has fewer than the number of employees the SBA has designated as the size standard based on a company’s applicable North American Industry Classification System Code.