PPP: Affiliation Guidelines

April 9, 2020

Authored by: Jim Havel and Robert Klingler

In determining eligibility under the Paycheck Protection Program, the SBA will aggregate “affiliates” of the borrower. This post further explores what the SBA considers “affiliate” of the borrower, based on the latest guidance from the SBA as of April 9, 2010.

How does the SBA Define “Control” for Aggregation Purposes?

The SBA’s standard definition of “control” for affiliation and aggregation purposes is a facts-heavy analysis similar to a totality of the circumstances standard. The SBA generally goes as high up and across the ultimate ownership group and its controlled companies when it comes to the entity deemed to control for aggregation/ affiliation purposes.

Control is both affirmative and negative best understood through use of examples:

  • For examples of affirmative control, see all of the tests below.
  • For examples of negative control, see Example 3 of Test 1 below.

Four tests will generally apply for affiliation based on control for PPP Loans.

Test 1 – Affiliation based on ownership:

Example 1 – Equity control: The classic and easiest example to understand is equity control. If an entity controls a majority of the equity (50%+1) of another business (or multiple businesses), the SBA will aggregate all of the employees of those companies together under PPP.

Example 2 – Voting stock is held by many investors: If the SBA determines no individual, concern or entity is found to control, the 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. Note: Question 3 on the PPP Loan Application requires borrowers to disclose whether the borrower or any owner of the borrower is the owner of another entity, or whether the borrower’s management team is in common with another entity’s management team.

Example 3 – Minority Shareholder (“negative control”): If a minority shareholder has the ability, under the concern’s charter, by-laws, or shareholders agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders.

Test 2 – Affiliation Arising Under Stock Options, Convertible Securities, and Agreements to Merge

The SBA considers every company fully-diluted for aggregation and affiliation purposes.

SBA will find affiliation in the event an investor holds stock options, simple agreements for future equity (“SAFEs”) or other document with the ability to purchase a controlling equity interest in a company regardless of whether the investor has exercised such rights.

In the event of a potential merger between two entities, the SBA will not aggregate the entities for affiliation purposes unless there is an executed merger agreement or similar transaction agreement between the parties.

An individual, concern or entity that controls one or more other concerns cannot use options, convertible securities or agreements to appear to terminate such control. SBA will not give present effect to individuals’, concerns’ or other entities’ ability to divest all or part of their ownership interest in order to avoid a finding of affiliation.

Test 3 – Affiliation Based on Management

Affiliation also arises where a single individual, concern or entity controls the management of the borrower through a management agreement. Please see Example 2 of Test 1 above.

Test 4 – Affiliation based on identity of interest

The SBA will find control/affiliation when there is an identity of interest between “Close Relatives” (a spouse, a parent, a child or sibling, or the spouse of any such person), with identical or substantially identical business or economic interests. This is a rebuttable presumption pending the close relatives’ ability to demonstrate their economic interests are not necessarily aligned and the businesses are run separately.

Which protective provisions does the SBA consider “controlling” when analyzing negative control?

The SBA uses a totality of the circumstances, facts heavy analysis. Therefore it is tough to determine which protective provisions will constitute control. SBA administrative case law has found the following protective provisions to create affiliation/aggregation: (1) dividend or corporate distribution powers; (2) establishing (or preventing) a quorum at board or shareholding meeting; (3) approving (or vetoing) capital expenditures or budgets; (4) determining employee compensation; (5) hiring and firing officers and directors; (6) changes to the company’s strategic direction; (7) amending incentive or ESOP plans; (8) incurring or guaranteeing debts/obligations; (9) corporate legal decisions; (10) corporate contract or joint venture opportunities; and (11) making/amending/terminating leases.

Which protective provisions does the SBA recognize as “not controlling” when analyzing negative control?

The SBA, in general, does not consider the following protective provisions to trigger “control”: (1) selling all or substantially all of the assets; (2) encumbrances on assets; (3) changes to capitalization; (4) line of business; (5) merger transactions; (6) issuing additional equity; (7) amending the organizational documents; (8) filing for bankruptcy or dissolving the company; (9) increasing or decreasing authorized capital of the company; (10) size of the board; (11) certain corporate legal matters; and (12) disposing of goodwill.

While these examples seem exhaustive, we cannot stress enough the SBA treats the affiliation and aggregation rules as a facts-heavy analysis.

VC and PE Affiliations

The SBA has not provided any additional guidance for the negative control example above. Venture capital (“VC”) and private equity (“PE”) portfolio companies generally take VC and PE capital in exchange for equity. Often, VC funds take minority equity positions which accompany standard protective provisions in the operation of the company (i.e. the ability for one shareholder to prevent a quorum or otherwise block action by the board of directors or shareholders). House Speaker Nancy Pelosi sent Treasury a letter at the end of March asking for an exemption for startups from SBA affiliation and aggregation rules. House Minority Leader Kevin McCarthy echoed Speaker Pelosi’s comments on a podcast in early April. The issue of affiliation with respect to private equity and venture capital-backed companies has not yet been specifically addressed despite strong prior indications of movement on this issue.

Question 6 of the Treasury’s PPP FAQ indicates borrowers do not have to aggregate potential affiliates if those affiliates holding negative control rights irrevocably waive them. We note the many companies accepting VC money have attempted this process with their VC contributors. While the rule appears to provide cover for certain borrowers, it is unclear whether irrevocably means “forever” or whether the entity holding negative control rights can waive them through a particular date and qualify for treatment under the FAQ during that time period.

Applicable Code of Federal Regulation Provisions

Please note, the SBA and CARES Act uses the 13 C.F.R. § 121.301(f) regulations for 7(a) loans. However, the CARES Act also refers to the SBA guidance in 13 CFR §121.103(c). In general, there is significant overlap between these sections with respect to the determination of “control.” The SBA does have a small business compliance guide which also addresses the question of affiliation. Please note the SBA’s general guidance is geared toward the 103(c) Regulations.

The Interim Final Rule clarifies that the affiliate rules that apply generally are those contained in 13 CFR 121.301(f)  (“301(f) Regulations”) and not 13 CFR 121.103(c) (“103(c) Regulations”), notwithstanding the statutory references to 103(c) Regulations.  This further strengthens the distinctions between the 301(f) and 103(c) Regulations, with the biggest distinctions being less reliance on concepts of negative control in the 301(f) Regulations. However, negative controls rules still apply in the 301(f) Regulations.

Faith-based Affiliations

While this article primarily focuses on for-profit organizations, the SBA has released an Interim Final Rule with significant guidance regarding an exemption from the rules on affiliation for PPP Loans for religious, faith-based nonprofit organizations.

Conclusion

The SBA’s affiliation and aggregation rules will undoubtedly cause some potential borrowers confusion, particularly in the venture capital and private equity community. BCLP notes members of Congress and the SBA have hinted at additional guidance for affiliation rules. As of the publishing date, the SBA has not provided such guidance. BCLP is ready and able to assist in aggregating your business’ employees for the purpose of applying for a PPP Loan under the CARES Act.