Startup team members in a discussion

One of the most significant provisions of the coronavirus stimulus package is the Paycheck Protection Program, which can provide forgivable loans to small businesses to help them maintain payroll. However, one of the key questions facing many startup businesses is whether the Small Business Administration’s rules might disqualify some small businesses that have venture capital funding. 

What Is the PPP?

Documents for a loan from the SBA

The Paycheck Protection Program (PPP) is a key feature of the Coronavirus Aid, Relief, and Economic Security Act (CARES) Act, better known as the government stimulus program.

This section of the stimulus creates a fund worth approximately $350 billion in forgivable loans to small businesses. The loans can be used to cover up to eight weeks of payroll expenses, as well as certain qualifying costs of overhead. (Note: Readers may also see PPP loans referred to as the new SBA 7(a) loans. This refers to the SBA’s loan guarantee program, which has been now updated to include the Paycheck Protection Program.)

Under the CARES Act, a qualifying small business will have its PPP debt fully forgiven so long as the business spends its money primarily on payroll. At least 75% of the forgiven amount must be spent on payroll, and the business must maintain both staffing levels and rates of pay. (A small business that lays people off or cuts pay will have this debt forgiveness reduced.)

This is a sweeping measure designed to subsidize business payrolls, encouraging them to retain workers in anticipation of a recovery rather than letting staff go across the board.

Why VC-Backed Startups Are Concerned

In the wake of the CARES Act, small businesses – defined as 500 employees or fewer – have worked to figure out exactly who qualifies for government aid. The SBA’s affiliation rule has raised particular questions on this issue.

This rule judges a business as small based on the number of people employed by both it and “affiliated” companies. The purpose is to prevent subsidiaries and branch offices of major corporations from taking advantage of a program designed to help new businesses and neighborhood restaurants. However, many startup companies have asked if they qualify as affiliates of the venture capital or private equity firms that invested in them. Since these firms typically invest in many businesses at a time, defining startups as affiliated with their investors has the potential to push them beyond the 500-employee limit. Under this interpretation, many of these startups would be disqualified from small business relief under the PPP and under provisions of the CARES Act.

What Is the Affiliation Rule?

The SBA defines a small business as one with 500 employees or fewer. The CARES Act extends this definition to the PPP:

“Small businesses with 500 or fewer employees – including nonprofits, veterans organizations, tribal concerns, self-employed individuals, sole proprietorships, and independent contractors – are eligible. Businesses with more than 500 employees are eligible in certain industries, which is one of the features that make the PPP different from other SBA loans.”

However, seeing whether you qualify is not a simple matter of taking a headcount of the people working in your office. The SBA applies what is known as the “affiliation rule” to calculate how many employees work for a given business. It says that if a small business is controlled by another entity – for instance, a parent company – then the controlling entity and all of its affiliates could count as a single enterprise.

Ordinarily the SBA says affiliation applies “when one business controls or has the power to control another or when a third party (or parties) controls or has the power to control both businesses” and control “may arise through ownership, management, or other relationships or interactions between the parties.” The SBA makes this judgment based on the totality of circumstances. Control can apply positively (the controlling company can tell its affiliate what to do) or negatively (the controlling company has veto power).

Real estate creates the classic example of affiliation. It’s common for management companies to split every property they own into its own company, typically an LLC. The central management group will then be another LLC separate from, but in charge of, all the rest. Under this structure a real estate empire can oversee and control thousands of employees at properties spread all across the world, even though each of those properties will technically be a company that only employs a dozen people.

The SBA doesn’t want that group taking advantage of programs designed to encourage small businesses.

Does Affiliation Apply to PPP Loans?

For some small businesses, administering the Paycheck Protection Program through the SBA has created an urgent issue. If your business has received funding from a private equity or venture capital firm, does this create a controlling relationship under the affiliation test?

If so, this would create a situation very similar to our landlord example above. The SBA would consider every individual business in which the firm invested part of a general network of businesses, disqualifying all of them from these small business loans.

Startup companies, however, have argued that this in no way represents the actual nature of their investor relationship. Most businesses with large investors operate independently, and they don’t become an operational franchise of the investing firm. They are an investment that will pay off based on the work of others.

Unfortunately, at time of writing, the SBA and the Treasury have not clearly stated whether they intend for affiliation to apply to private equity or venture capital-backed businesses.

It Likely Depends on Whether the PPP Is a ‘Disaster Loan’

PIcture of a $100 bill as a bridge over a chasm

Much of the question has to do with the wording of statute 13 CFR §121.103(a). This section defines the SBA’s general principles of affiliation, and it does so relatively broadly. However, this section does not define affiliation for applicants under the SBA’s “business loan, disaster loan, and surety bond guarantee programs.” For those loans, the SBA defines affiliation in 13 CFR §121.301(f).

Here’s why this is so important.

For a startup company with private equity or venture capital investors, affiliation will generally be based on stock ownership. The investing firm will own a portion of your business, and that ownership stake will generally give them a measure of either positive or negative control.

Both Section 103 and Section 301 agree that if an outside investor owns or controls at least 50% of the voting shares of a business, then he controls the business for the purposes of affiliation. However, if no single investor controls a majority share of the business’ stock, the two sections diverge.

Under section 103, which controls general SBA 7(a) lending, outside investors are considered to control the business if a small number of people control a plurality of the business’ stock. Specifically, the section calls for a presumption of affiliation if:

“[T]wo or more persons (including any individual, concern or other entity) each owns, controls, or has the power to control less than 50% of a concern’s voting stock, and such minority holdings are equal or approximately equal in size, and the aggregate of these minority holdings is large as compared with any other stock holding.”

Section 301, which controls affiliation in the case of disaster lending, does not cover plurality ownership. It only calls for affiliation if a minority shareholder in the business has veto power over its decisions. (Section 103 shares this veto rule.)

The result here is that if the PPP is considered general SBA lending, then section 103’s plurality rule will apply. Many startups will find that their private equity or venture capital investors constitute a small number of firms each holding a plurality share of stock in the company, which in turn will legally affiliate that startup with the investment firm and any other startups that firm legally “controls.”

If the PPP is considered disaster lending, then section 301 applies. This section has no plurality rule. So long as no single investment firm controls a majority of shares, startup firms will most likely be considered independent of their investors.

So What Should Startups Do?

In its latest guidance on PPP loans, the SBA acknowledged the confusion over the affiliation rules, and noted that it “intends to promptly issue additional guidance with regard to the applicability of affiliation rules” to the loans.

In the meantime, some general principles apply.

No matter what, a startup company will most likely be considered affiliated with an outside investor in one of two situations:

  • If that investment firm controls 50% or more of the startup’s stock
  • If that firm has the power to exercise an absolute and unilateral veto over company actions.

In that case, you should begin working with your investor. First, discuss how many other businesses they currently invest in and the total employee count across this network. It’s possible that even with the affiliation rule in place, you will not cross the SBA’s 500-employee threshold. Otherwise, begin to determine next steps through alternative relief programs.

Your best course of action is to contact a lender. The SBA has published a tool to search for eligible lenders in your area. Begin the application process for a PPP loan while being absolutely clear about your investor relationships. Lenders have a surprising amount of discretion when it comes to approving a loan, but hiding potentially relevant information is a federal crime. It’s much better to risk having your loan rejected today than getting a call from the Treasury tomorrow.

Tips for Small Business Owners

  • Many financial advisors specialize in working with business owners. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • Learn about other programs that can help struggling small businesses. Some of these programs are grants, some are debt relief and some are loans.

Photo credit: © gin tan, ©, ©

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