SBA Issues Affiliation Rules for Paycheck Protection Program

April 7, 2020Alerts

The Small Business Administration (SBA) issued guidance on April 3, 2020, about Affiliation Rules applicable to the U.S. Small Business Administration Paycheck Protection Program (PPP), part of the Coronavirus Aid, Relief and Economic Security Act (CARES Act). At the highest level, the PPP allows eligible businesses to borrow up to 2.5 times the average monthly payroll costs from the previous year, subject to a $10 million cap. 

While many had hoped Treasury Secretary Steve Mnuchin would waive the SBA’s existing affiliation rules, the Interim Final Rules and guidance confirm that many of the affiliate rules remain applicable and a number venture-backed companies may be precluded from borrowing under the PPP, despite that certain rules applicable to PPP loans are less restrictive and easier to apply than the current rules. 

Affiliation determinations

Affiliation determinations are significant under the PPP in that the applicant and each “affiliate” is viewed as one business for purposes of calculating the number of employees. Subject to certain exceptions, only businesses with 500 or fewer employees whose principal place of residence is in the United States in operation on February 15, 2020 are eligible to borrow under the PPP. Under the CARES Act, the SBA’s affiliation rules are waived for (i) businesses that fall under NAICS code 72 (the hotel and food service industries) as of the date of which the loan proceeds are disbursed, (ii) franchises listed in the SBA’s Franchise Directory, and (iii) businesses which receive funding from a Small Business Investment Company.

Because PPP applications are reviewed on a first-come, first-served basis, and the affiliation rules are fact-specific, interested businesses are encouraged to diligently obtain the necessary application materials and work with knowledgeable professionals when needed. 

Entities are deemed affiliates of each other when one controls or has the power to control the other. It does not matter whether control is exercised, so long as the power to control exists.

Affiliation based on ownership
A shareholder is an affiliate of a business if it owns or has the power to control more than 50% of the business’s voting equity. In addition, a minority shareholder is an affiliate of a business if it has the right under the business’ charter, by-laws, or shareholder's agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders. In the absence of an entity owning more than 50%, control is determined based on the Board of Directors, President or Chief Executive Officer.

While the PPP affiliate rules may not be helpful for private equity owned businesses because private equity investors typically own more than 50% of the voting equity of their portfolio companies or for venture-backed companies with typical negative covenants which give a single investor  the ability to block certain board or shareholder actions, these rules will help venture-backed companies with multiple venture investors if no single investor owns more than 50% of the voting equity or has the right to prevent a quorum or otherwise block action by the board of directors or shareholders. In addition, the PPP affiliate rules eliminate the SBA’s prior rule of aggregating investors to find affiliation where a small group of investors collectively own more than 50% of the voting equity.  Finally, the PPP affiliate rules relating to contractual rights indicating control are more objective and easier to apply than the prior rules.

Affiliation arising under stock options and convertible securities
When determine control, the SBA considers stock options, convertible securities, and agreements to merge as having a present effect.  The SBA will not give present effect to rights or options to divest from a business.

Affiliation based on management
Affiliation arises where a CEO or President (or other controlling individual) also controls the management of one or more other concerns.  Affiliation may also exist when one individual or concern has the ability to exercise control by way of a management agreement.

Affiliation based on identity of interest
Affiliation may arise when close relatives, as defined in 13 CFR 120.10, have identical or substantially identical business or economic interest (such as when relatives operate businesses in the same or similar industry in the same geographic area).

If you have questions about the Paycheck Protection Program, Economic Injury Disaster Loans, SBA loan programs or other corporate law questions, please contact Gabriel Herman at [email protected] or at 215.444.7338, Diana R. Palecek at [email protected] or 704.384.2609, Thomas A. Letscher at [email protected] or 612.607.7443, or Tamar R. Gubins at [email protected] at 212.878.7974.