CARES Act: ‘Affiliate rule’ restricts eligibility for venture-backed companies
Our Navigating Uncertainty session, Venture-backed Company Eligibility for CARES Act Forgivable Loans, was rapidly assembled just days after the Act was signed into law. Widespread interest in the subject was reflected in a flood of registrations, and more than 1,200 business leaders in attendance.
Contained in the CARES Act signed into law March 27, 2020 is the Payroll Protection Program (PPP), a $350 billion forgivable loan facility available to small businesses. The urgent need for relief is being felt by small businesses across the country, including venture-funded businesses, whose eligibility for participation in the PPP is not assured.
At issue, is whether or not venture-backed companies are subject to the SBA’s “affiliates rule.” A venture fund (and some or all of its portfolio companies) may be affiliated with the applicant if the fund has certain control rights, or owns 50% or more of the company, and so the “employee” count for a company may include employees of the venture fund and employees of some or all of its portfolio companies. Since companies cannot have more than 500 employees to be eligible, the affiliate designation can result in swelling the employee count above 500.
Airbase Founder/CEO Thejo Kote was joined in discussion with two nationally recognized attorneys, Michael Kendall, Co-head of Goodwin's Private Equity Group and Kathryn Hickey, partner, Government Contracts Practice of Piliero Mazza. Our two panelists were particularly well qualified to address the issue and to provide suggestions on how to possibly overcome the affiliate rule hurdle. Both are members of the National Venture Capital Association task force that provided input to the CARES Act.
Mr. Kendall pointed out that most venture-backed businesses have a group of minority owners who, together, have common control through the negative covenants contained in their investor agreements. A helpful summary of the Negative Covenants that are Likely to Create Affiliation between a Company and a Minority Investor can be found on page 3.
The panelists talked about the possibility of breaking affiliation with a venture firm by using a temporary waiver of investor rights. It was suggested that venture-backed companies may wish to explore the benefits of a temporary waiver with their legal counsel and investors in order to qualify for the PPP.
Another issue that may be relevant to some VC-backed firms with existing runway is the certification of need. Businesses will be asked to certify (most likely a box to be ticked) that they have a need for the funds due to the economic downturn resulting from the coronavirus outbreak.
Ms. Hickey talked about the test for “need” and noted that it is not fully defined, but it may not necessarily be confined to business insolvency. It could possibly extend to loss of cash flow to meet payroll obligations; inability to meet payroll; need to reduce headcount or reduce salaries; and possibly a shortening of runway.
The panelists were clear to point out that there will be enforcement attention on the distribution of the loans, and that false statements, fraud, or knowing or reckless misrepresentations could have civil and criminal consequences. In the days following our Navigating Uncertainty session, Goodwin law released an article warning that audits and lookbacks will be conducted and possible false or misleading statements will be scrutinized by both state and federal authorities well after the crisis is over. You can find their Enforcement Risks for Recipients of U.S. CARES Act article here.
Here is a link to our FAQ PDF about the PPP.
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The Legal Risks Associated with PPP Loan Applications.
In spite of recent clarifications, legal exposure remains for companies who apply for PPP loans.