April 20, 2020
Recent Impacts on Venture- and PE-backed Entities
Posted by COVID-19 Rapid Response Team
The initial funding for the Paycheck Protection Program (PPP) and Economic Injury Disaster loans (EIDL) ran out quickly, but Congress has approved and the President has signed another round of funding this week.
Let’s recap what was and what could be with proper planning.
The primary purpose of the CARES Act, as it relates to government financial assistance programs, was the introduction of the PPP and a continuation of the SBA’s EIDL program. These separate assistance programs are designed to help small businesses address significant cash flow issues and related business expenses specific to the impact of coronavirus. Unfortunately, and for the Bay Area particularly, a significant number of businesses felt their participation was not applicable due to their VC/PE funding and the affiliate attribution problem. Once a concern (corporation in this case) falls into an affiliation with other VC/PE companies, the 500-employee count was missed and thus, was a disqualifier. We say, not so fast; let’s take a closer look at some of the rules to review before you walk away from up to $10 million to aid your payroll burden for the coming months.
Affiliate attribution does boil down to “control” but there are avenues to provide relief around these control features that many are not considering today. From a basic perspective, the SBA focuses on affiliations that fall within the categories described below. There are multiple exceptions, also discussed below, but there are four primary affiliations that restrict access:
- Affiliation based on ownership.
- 50% of the concern’s voting equity.
- If no concern owns 50% of more, SBA will deem the board of directors, president or CEO (or other officers, managing members, or partners who control the management of the concern) to be in control of the concern.
- SBA will deem a minority shareholder to be in control, if that concern 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 arising under stock options, convertible securities, and agreements to merge
- Affiliation based on management
- Affiliation based on identity of interest
- Defined as between close relatives, as defined in 13 CFR 120.10, with identical or substantially, identical business or economic interests
The SBA also lists areas where there exist exclusions (what is defined below are not exhaustive). For financial, management or technical assistance the following exceptions apply:
- Venture capital operating companies, as defined in the U.S. Department of Labor regulations found at 29 CFR 2510.3-101(d)
- Employee benefit or pension plans (ERISA of 1974, as amended (29 U.S.C. 1001, et seq.)
- Charitable organizations exempt under section 501(c) of the Internal Revenue Code of 1986, as amended (26 U.S.C. 501(c))
- Investment companies registered under the Investment Company Act of 1940, as amended (1940 Act) (15 U.S.C. 80a-1, et seq.)
- Investment companies, as defined under the 1940 Act
Given these factors, if control conditions do exist, then there is a strong probability that affiliate attribution will apply. In speaking to Bay Area CEOs and CFOs, structural reductions in workforce will happen. This is bad for business, trade secrets, and competition. The government program is designed to prevent this from happening. So what should we do?
The simplest and most logical approach is for the Treasury Department to align with SBA and remedy this problem, either directly or through a waiver program. We still maintain hope for such relief. Outside of a systemic fix, this can still be solved by action through business charter and certain collateral shareholder rights agreements. Generally, these agreements contain elements that would cause control elements that will drive to affiliation. In discussion with professionals around the Bay Area, many had concerns that modifying agreements after the fact is not appropriate. However, in the FAQs produced by the SBA, question six clearly showcases that not to be the case, specifically “If a minority shareholder in a business irrevocably waives or relinquishes any existing rights specified in 13 C.F.R 121.301(f)(1), the minority shareholder would no longer be an affiliate of the business.”
There are other corrective measures to alleviate control and thus, remove the affiliate rule and qualify VC/PE backed companies. For up to a $10 million loan from the government that essentially becomes a grant that is nontaxable with proper spending and controls, CEOs and CFOs fiduciary duty would urge them to look at the details. If for any other reason outside of that responsibility, the obligation to maintain your workforce and the livelihood of the employees is at stake.
The first round had companies like Ruth’s Chris Steak House with 5,000 employees receiving PPP funds, one of over 50 publicly traded companies. Now exceptions apply to restaurants, but there are exceptions in NAICS codes, as well. And yes, there are a host of VC-backed companies who received funding. Proper analysis should be given to qualifiers. The time to act is now.
We’re Here to Help
We’re closely monitoring the hour-by-hour changes, and we will send out updates as they become available. Reach out to our Rapid Response Team below if you need further information on this topic.
These are unprecedented times. And we know you, your families and your organizations need support, now more than ever. Our top priority as your trusted advisor is to ensure we’re helping you through these tough times. Visit COVID-19 Rapid Response Resource Center for our crisis management resources and contact information for our COVID-19 Rapid Response Team Leaders.