Many presume that the SBA’s “affiliation” rules will prevent venture-backed startups from applying for loans under the Paycheck Protection Program (PPP) of the CARES Act. I think that’s unfortunate, because the potential benefits of a PPP loan are compelling. For sure, you’re prudent to assume that, if you’ve closed on one or more preferred stock financings, your startup will indeed have an affiliation issue, based on protective covenants found in your charter and investor agreements; but you may be pleasantly surprised to hear of ways to amend your startup’s governing documents that, at least arguably, do not do essential violence to minority investor protections.
Because the terms of the PPP are so compelling – a loan that becomes a tax-free grant if spent on payroll, rent and utilities (in essence, for earlier stage startups, your burn) – it simply has to be looked at as a financing source. If the initial problems with the SBA’s rollout of the PPP can be fixed, this program may be the best way out there to mitigate the uncertainties that arise from the global pandemic. The brutal reality is that your next priced equity round is significantly further down the road than you had planned.
At the same time, no one wants to re-trade on essential terms with their startup’s preferred stock investors. The affiliation “fixes” should, if they are to be feasible, focus on preferred stock class voting thresholds or the makeup of voting groups in your charter and/or to selectively eliminate preferred director veto power in your Investors’ Rights Agreement.
Let’s step back for a second and address another common misperception: it’s important to understand that an affiliation analysis is distinct from application disclosure requirements driven by the PPP’s 20% owner threshold. The 20% threshold pertains to the scope of information an applicant needs to provide, what representations need to be made, and the like. An affiliation analysis, by contrast, speaks instead as to whether the applicant even qualifies as a “small business.” For the most part, this means, will the SBA deem the applicant to have fewer than 500 employees. If your business is “affiliated” with other startups in your VC firm’s (or firms’) portfolios, your company may be deemed big, not small, and so not eligible for the PPP.
So put the 20% ownership threshold aside. Here is the key question to ask in the affiliation analysis: do you have a minority investor (20% does not matter for this analysis; VC firms that own less may indeed be deemed “affiliated”) which controls protective covenants in your charter, or which controls a board seat afforded certain veto rights on board decisions? If the answer to either fork of that question is “yes,” you almost certainly have confirmed that you will need to amend your charter and/or other governing documents before proceeding with a PPP application.
A next step in an affiliation analysis is to categorize each of the protective covenants (hereafter, I’ll call them “negative covenants” to better align with the nomenclature of the relevant SBA administrative case precedents that drive the discussion) in your company’s organizing and corporate documents. This set of documents will, as noted above, include your company’s charter and almost certainly its Investors’ Rights Agreement. And it may include other documents.
Once the relevant set of negative covenants are identified, a next step is to assess, with counsel, which negative covenants might be legally deemed more purely “investor protective” in nature, and which may be deemed instead to impinge on the company’s independence in making operational decisions. Keep in mind that this is not an exercise in determining whether you made a bad deal with your VCs. As the NVCA and others have known for years, the SBA’s idea of what negative covenants are okay, and the venture industry’s view of standard protective covenants, do not align. (I say that the NVCA has known this for years, based on what I find in this SBA appeals board decision from 2011, referencing an NVCA brief objecting to the SBA’s views.)
As you delve into this arena, you will surely want to reference the lists of likely permissible and likely non-permissible negative covenants that have been posted by the NVCA. Others also consult a similar list posted by Pillsbury. And there are others. At the boutique law firm in Seattle where I practice, my colleague Adrienne Saltz has reviewed the SBA appeals board cases herself, to develop my firm’s own working categorization of negative covenants. Here is my firm’s current list:
Provisions that may suggest affiliation
Provisions that likely do not suggest affiliation
|Approving a director
|Approving new shareholders or withdrawal of old shareholders
|Preventing a quorum or otherwise blocking an action by the board of directors or shareholders
|Increasing or decreasing the size of the board of directors
|Hiring and firing officers or executives
|Increasing, decreasing, or reclassifying the authorized capital of the company
|Setting compensation of officers or employees
|Issuing additional stock or equity
|Power over the corporate budget, incentive plan, or accounting methods
|Amending the company’s organizational documents
|Alienating or encumbering assets, so long as they are less than all or substantially all of the company’s assets
|Selling, mortgaging, or encumbering all or substantially all of the company’s assets
|Creating debt such as when borrowing money (even when that power is accompanied with a dollar limit)
|Disposing of the company’s goodwill
|Incurring expenses such as when purchasing equipment (even when that power is accompanied with a dollar limit)
|Power over any matter that could result in a change in amount or character of the company’s contributions to capital
|Paying dividends (even when that power is accompanied with a dollar limit)
|Approving the company’s new business venture that is substantially different than previous business(es)
|Power over the strategic direction of the company (e.g., the establishment of new goals and new methods or plans for realizing those)
|Committing to take any action that would make it impossible for the company to carry on its ordinary course of business
|Power over non-competition provisions that limit the company’s ability to engage in certain businesses
|Power over any act that would violate the company’s organizational document
|Choosing an independent auditor
|Initiating a lawsuit or arbitration, or entering into a confession of judgment
|Amending or terminating current leases
|Dissolving the company or filing for bankruptcy
Now, when you go through your documents and cross reference your investor covenants with such a list, you are going to identify problematic negative covenants. Again, some commentators may say you are out of luck and should move on, but don’t despair. The range of possible solutions is broad, but here are two potential paths that your investors may be more amenable to discussing than you think:
- Amend preferred stock voting thresholds in your charter, so no single minority investor controls a negative covenant on the control/affiliation side of the ledger; and/or
- Amend your Investor’s Rights Agreement to cull preferred director veto rights over matters that the SBA may deem operational.
If it happens to be the case that your VC investor or other relevant minority investor is new and has a relatively small portfolio, you might ask them to work with you and persuade you that affiliation will not be a problem. That is, you may go ahead and embrace the affiliation within the meaning of the SBA’s rules, knowing that the employee number in all your “affiliated” companies does not tally to 500.
If it isn’t already obvious, I am of course suggesting that you go through a bespoke analysis in close consultation with your startup’s legal counsel, equipped with all the relevant facts and circumstances. But why not engage? The process should not be nearly so open ended as looking for a bridge round. In a cycle of a few days, you should be able to determine whether it will be feasible to resolve your “affiliation” issues. If you can, the other requirements for a PPP loan aren’t likely to be as thorny.