Unlocking Forgivable Loans for Investor-Backed Companies
The Small Business Administration announced yesterday the suspension of the Paycheck Protection Program (the PPP) under the CARES Act, after applications outstripped the program’s $349 billion of funding. In spite of the headlines about stalled efforts to approve more funds, we expect that a second wave of funding will restart the program in the next week.
The PPP provides for forgivable loans to cover two months of payroll and other basic expenses. Forgiveness is automatic so long as the recipient satisfies certain conditions. So, for all practical purposes, most or all of the loan amount could be considered a federal grant.
To qualify, an applicant must be a small business, defined in most cases as having no more than 500 employees. In the first round of the program, many private investor-backed companies did not apply for the PPP forgivable loans. Complicated affiliation rules that required applicants to count toward the 500 employee limit the employees of their investors’ businesses discouraged participation. In addition, investors balked at a requirement to provide as part of the application a list of all of the businesses in which investors hold ownership stakes.
We believe it will be easier for companies to participate in the next wave of funding because the SBA recently clarified certain aspects of its affiliation rules. The clarification opens a clearer path for an applicant to avoid aggregating its employees with the employees of its investors’ other portfolio companies for purposes of the size limit.
From an investor perspective, however, the PPP benefits come with tradeoffs. Applicants will still need to disclose the portfolio companies of certain investors. And for companies to access the loans, investors must waive or remove by amendment consent rights that are often included in financing deals. On the other hand, if investors facilitate PPP applications, they can unlock potentially substantial non-dilutive grant capital for their portfolio companies.
The affiliation rules require aggregating the employees of all companies “controlled” by an investor. The investor is considered to control a company if the investor owns the majority of voting equity, has the power to block actions of the board or its committees, or has veto rights with respect to what the SBA considers to be “ordinary” business matters.
Investors may retain consent rights that concern “extraordinary” business matters, which the SBA believes are designed primarily to protect their investment rather than to exert control over day-to-day business decisions. Below are examples of consent rights that may be retained (Extraordinary Actions) and consent rights that make companies potentially ineligible for PPP loans (Ordinary Actions).
|Ordinary Actions (“Not ok”)||Extraordinary Actions (“Ok”)|
As we represent only impact investors and mission-driven companies, we assessed the SBA affiliation rules from a different perspective than conventional law firms. Based on our evaluation, we believe impact investors and mission-driven companies should consider the following:
1. As with investors generally, impact investors are reluctant to finance companies that they believe will have a lower likelihood of surviving the current economic crisis. With limited financial and human resources, impact investors are understandably focused on sustaining companies with the strongest prospects to thrive once the crisis ends. All investors are faced with this kind of triage at the moment. We would hope, however, that impact investors may be more willing than other investors to relax certain conventional control rights for portfolio companies that they’re not actively supporting.
2. Investors who have experimented with equity investments that rely on dividend payments and redemptions to drive returns rather than conventional exits, probably have placed restrictions on the ability of these companies to pay dividends and redeem stock. A blanket veto right over dividends and redemptions would trigger the problematic affiliation rules. We believe, however, that with some creativity it is possible to maintain the essence of these deals even with the waiver of customary veto rights.
3. We believe the common mission protection clauses listed below should not by themselves trigger the affiliation rules. In other words, we believe retaining these mission protection clauses should not jeopardize a company’s PPP application.
- Requiring investor consent to change the benefit purpose of a public benefit corporation.
- Requiring investor consent to discontinue the mission-related business or to enter into a new line of business.
- Requiring impact reporting.
With such an overwhelming amount of COVID-19 information out there, we tried to make this blog as non-technical as possible. We’ve tried to capture the essence – rather than the nuance – of these extraordinarily complicated rules. If you would like to geek out on more detail, we suggest this guidance from the National Venture Capital Association:
Nothing in this article is meant to constitute legal advice
or create an attorney-client relationship.