On March 27, 2020, President Trump signed into effect the Coronavirus Aid, Relief, and the Economic Security Act (the “CARES Act”), which includes, among other relief provisions, the Paycheck Protection Program (the “PPP”) aimed at providing liquidity to help small businesses maintain their existing payroll by making certain (forgivable, in part) loans available through the Small Business Administration (SBA). On April 2, 2020, the SBA issued its Interim Final Rules regarding the administration of the PPP, which provides the framework under which businesses with under 500 employees (generally) can take advantage of the PPP, if they certify that “current economic uncertainty makes this loan request necessary”.
Venture and PE Back Entities and the Affiliate Attribution Problem
Unfortunately, for a large swath of the small business community, including many start-ups, the rules around PPP eligibility present a significant roadblock to their participation. Since the program is administered by the SBA, the SBA’s general rules and regulations are applicable to the program. One particular aspect of those rules, regarding how to count ‘employees’—the so called “Affiliation” rules—is problematic in that it may require attribution and aggregation of employees with other ‘affiliates’. In this context, it is suggested that affiliates may have to include any investors who hold a ‘controlling interest’ in the company and any other companies in whom that investor also holds a controlling interest.
With that level of attribution, it becomes highly likely that any given investor (often, PE, VC or even Angel) backed company will quickly exceed the 500 employee maximum level under the PPP, and, therefore, will not be eligible to participate. With time being of the essence, and an already limited (and rapidly dwindling) level of available PPP funds to access, it is imperative that these businesses—often some of the US’ most promising young enterprises, including in the biotechnology space—proactively find a safe and compliant way to participate in this important economic stimulus (or ‘emergency distress relief’, depending on your perspective) program.
At the heart of the problem here is what constitutes a ‘control investor’ under the applicable SBA regulations. We will not attempt, in this column, to explicate the nuances around every direct and edge case that might constitute control. Others have done a great job summarizing and explaining the same (including an excellent rule / example chart here). Suffice it for our purposes to say, however, that ‘control’ can be expressed or implied as a result of any of the following conditions:
- Common Ownership – Ownership of >50% of voting equity.
- Present Effect – The rules will give present effect to potential future events, such as the exercise of options, warrants, etc., that could affect control.
- Common Management – Where sister entities share controlling executive officers and/or directors, for example.
- Identity of Interest (Family Relationships) – Where sister entities are owned / controlled by close family members.
- Identity of Interest (Economic Dependence) – Where a company derives 85%+ of its revenues over the previous 3 fiscal years from another entity.
- Identity of Interest (Common Investments) – Where management / shareholder groups have substantial investment and economic overlap with other entities.
- Newly Organized Concern – Applicable where a key stakeholder in one entity begins to perform work for another, and maintains substantial overlap of resource usage from the old entity.
- Successor-in-Interest – Applicable in cases involving a consummated strategic transaction, where the successor may be aggregated with the predecessor entity.
- Totality of Circumstances – When the facts and circumstances suggest that two companies are very closely intertwined, they may be deemed affiliated.
As mentioned above, in the event that a control condition exists, then it is highly likely that attribution with an investor and with the investor’s other portfolio companies will exist, such that the employee headcount metric for any given company could be significantly increased, resulting in PPP ineligibility.
Suggesting a ‘Workaround’ Framework
In our view, the best and most logical outcome here is for the Treasury and the SBA to directly fix this problem—either by updating their rules and guidance, or by issuing waivers. As of this writing, we remain hopeful of the probability of that outcome.
However, in the event that this does not happen, it may fall to business and legal advisers to consider creative ways that their clients may stay outside of the attribution rules, and still fit within the letter and spirit of the PPM framework.
We would suggest that there are three obvious ways to potentially deal with (portions of) this issue, and they all involve the full participation of the investor community.
- Note – For the sake of brevity and clarity, the following analysis is based on and assumes a Delaware domiciled for-profit corporation, which has adopted standard NVCA investment documentation, and which requires a simple majority of preferred holders to effect charter / material document modifications or waivers (that being the ‘Requisite Holders’).
What We Believe Can be Solved For by Action…
Solving for any of the control issues detailed above is almost certainly going to require manipulation of existing provisions in companies’ Certificates of Incorporation and possibly Bylaws (collectively, the “Charter”), as well as certain collateral shareholders rights agreements (inclusive, broadly, of the typical Investors Rights Agreement, Right of First Refusal (“ROFR”) and Co-Sale, and Voting Agreement). Collectively, these documents contain a number of provisions that are, generally, prophylactically protective of investors’ rights, that may cause attribution control issues. Specifically, investors are often granted dedicated board seats and certain investor protective provisions (veto rights) over certain key material company transactions. Depending on the existing deal in place, investors may also have conversion rights that give them effective voting control (under the ‘Present Effect’ prong), which are likely baked into the Charter documents.
Individually or collectively, these rights almost certain cement a ‘control’ relationship, that would put any such company squarely in the attribution dead-zone described above.
We believe, however, that a mix of the following techniques could be effective in rebutting a number of these presupposed conditions.
The most obvious and robust place to start unwinding disqualifying ‘control conditions’ is in the company’s Certificate of Incorporation (and any corresponding provisions in the company’s Bylaws, if any). In the standard NVCA form, this will also certainly involve direct amendments to the Board of Directors composition / voting section, as well as the Preferred Stock Protective Provisions Section (both usually contained in Section 3 of the NVCA model form of Amended and Restated Certificate of Incorporation).
What we would suggest is that an abrogation of the rights contained in those Sections may be directly necessary in order to comply with certain of the control conditions detailed in the rules. Each situation could, of course, be slightly different, so a universal approach is likely impossible, but the principals around what would need to be changed should be fairly universal.
Or, what if a more universalist approach, is possible? For example, what if, a company and investors representing the Requisite Holders could agree to some form of the following new, ‘temporary’ Article in a standard Certificate:
FOURTEENTH: For purposes of the rules of the US Department of the Treasury and the Small Business Administration (to the extent applicable) (the “Rules”), in connection with any loan obtained by the Company under the Paycheck Protection Program (PPP), for so long as any principal or interest may be outstanding under such loan, all holders of [Series A Preferred Stock] agree that the provisions contained in Article FOURTH, Section B of this Certificate related to preferential voting by such holders on any matters, including, but not limited to matters related to the Board of Directors and any special protective provisions shall be fully suspended, and that such holders shall, in lieu of such rights, be entitled to vote on any or all such matters on a theoretical as-converted to common stock basis only. This provision shall be automatically abrogated, and shall be of no further force or effect, upon the earlier of (i) the repayment, forgiveness, novation or other extinguishment of such loan and the Company’s obligations with respect thereto, or (ii) any modification of the Rules that would no longer necessitate the same, as a condition of participation by the Company in the program(s) underlying such loan.
The benefits of this approach are obvious. It is relatively simple and easy to implement. But would it be respected by any examining authorities, and be sufficiently ‘unambiguous’ not to fall foul of the law of unintended consequences on other matters? These may not be answerable without some leap of faith (which, of course, will put a lump in legal counsel’s throat). But we would suggest that, if the now fairly standard Certificate provision dealing with Section 500 of the California Corporations Code (dealing with certain repurchases) is working in Delaware Certificates, then there is no obvious reason why some version of this approach should not also work.
Waivers are the fastest and easiest way to deal with required corporation actions. The model NVCA Certificate provides a simple and easy to use waiver provision for use by the preferred Requisite Holders (See Article FOURTH, Section B.8.). In theory, this provision could be used, in a blanket fashion, to obtain well designed and thorough waivers from preferred holders to address one or more blocking control conditions (including all those mentioned above). Another benefit of waivers is that they are much easier to update, modify, repeal, etc., in the event that the same is required by any regulatory authority, and/or the underlying conditions for their need have ceased to exist.
However, effecting by waiver everything which is necessary to mitigate away control condition risk seems unlikely. For one thing, it may not be obvious how the regulatory authorities (or a Delaware court, for that matter), would treat a ‘waiver’ of an otherwise obviously codified right in the Certificate (such as a Board seat nominating right), and such an approach seems like a recipe for corporate governance ambiguity. Further, it is not obvious how the regulatory authorities would view a waiver, that may otherwise have legal revocability, in light of the ‘Present Effect’ and ‘Totality of Circumstances’ prongs; and may choose to look through the same.
Accordingly, although useful (and, in the case of non-Charter documents, perhaps perfectly adequate), we would suggest that the Charter Amendment approach is an obviously more robust and defensible approach, if possible to actuate.
Business Structuring / Recusals
It is somewhat less clear whether provisions that provide conditions of control that are contained within collateral company documents (such as, e.g., the IRA, Voting Agreement and ROFR Co-Sale), as opposed to the Certificate and Bylaws, would also have to be amended, or whether waiver would be sufficient; especially since these documents are a matter of contractual private relationships, not public record. However, in the interests of caution, we would suggest that corresponding amendments and/or waivers also be cascaded down to these documents. Afterall, there is no point in committing to this strategy and amending a company’s Charter only to fumble the ball on technicalities at the five yard line. Accordingly, we would recommend corresponding changes / waivers to these documents as well.
Further, in order to deal with certain remaining prongs of the control relationship tests, we would suggest that intelligent business structuring and recusal strategies can be actuated (and documented) in order to solve for issues presented by the ‘Common Management’, ‘Identity of Interest – Family Common Investments’, and ‘Newly Organized Concern’ prongs. For example, careful investor divestiture of interest in certain entities (choosing carefully, obviously), recusal or resignation from certain boards / management roles for sister entities and/or a rethinking of certain strategic plans of portfolio companies may all be useful techniques to deal with issues in these verticals.
What May Not be Solved For…
Some of the control conditions above will simply have to mechanically ‘not be the case’, as they can’t practically be solved for in legal documentation alone. Those would include, self-evidently, the ‘Common Ownership’, ‘Identity of Interest – Family Relationships’, ‘Identity of Interest – Economic Dependence’ and ‘Successor in Interest’ tests. Accordingly, not every business is going to be eligible here, no matter what is undertaken.
Further, the ‘Present Effect’ rule presents a possibly serious problem here as well. Charter amendments and waivers are clever, but, if they contain obvious snap-back provisions that make them, essentially, perfunctory in nature, then it is likely that any examining authority would view them with a jaundiced ‘substance over form’ eye. We would suggest that any changes that have true substantive effect, and are not reversable for the life of the PPP loan should be respected as satisfying the spirit of the program, and, thus, out of reach of the Present Effect prong, but, admittedly, this is, perhaps, a tautological conclusion.
Lastly, the ‘Totality of Circumstances’ test (a perpetual law school and legal profession favorite!) is never going to be completely solvable. If it walks like a duck and quacks like a duck, it’s a duck. However, what we would suggest is that if this prong is to be solved for, it will have to come from the Treasury / SBA itself in public guidance (i.e., something akin to a ‘no action letter’, for properly structured workarounds). Doing so would send a strong signal to the business and legal community that the government is not hostile to this process, and, in fact, encourages its use.
Investor ‘Buy-in’; the Big Unknown
There is no practical way to implement the foregoing without buy-in from the investor community. None.
If investors are not willing to work with their portfolio companies to actuate a mixture of the foregoing strategies (as different use cases require), then the possibility of the same is a purely academic exercise. And many of these choices may be difficult and imperfect, under the heat of the moment on a compressed timeframe. For example, how can an investor reasonably and responsibly choose, in, say, 72-hrs, which of its portfolio companies has the ‘best chance’ to succeed and should pursue the PPP program, and in which of those it should simply resign its Board seat? … Investors will have to pivot to a mindset of trust, greater good and long-term thinking to effectively hedge risk in such matters.
However, we would suggest that this is likely in the best interests of basically all investor portfolio companies and the investors themselves. For most businesses, there would appear to be very little downside to participation in the PPP. In fact, for most, it may be a crucial survival lifeline, at a minimum, and possibly even a booster rocket to spur growth and innovation (which the US always, always needs more of, in the best and worst of times). If the alternative is the failure of one or multiple investor portfolio companies, then we would suggest that the waiver or abrogation of certain investor rights, temporarily, is a trifling matter to accept.
We would also suggest that, if pressed, most investors will accept the foregoing logic (with the admittedly very large caveat assumption, of course, that their own fund charter documents will even permit them to do so). In fact, we would suggest that the investor (PE, VC and Angel communities) will likely embrace at least some of the solutions to this dilemma (the foregoing, and others that will undoubtedly be forwarded in the days to come), in light of the unappetizing alternatives that are very much in play here.
Having said that, it is impossible to predict in advance. As an admitted digression, but by way of example, we have been arguing to anyone who would listen for 8+ years now that it is time to do away with Legal Opinion delivery in Series A rounds, as nothing but a pointless, expensive waste of scarce time and resources, but we are still swimming upstream against larger law firms on that fight! Here is to hoping that times may be changing in creative and cost-effective legal practice.
Will it Work? The Fine Print…
The foregoing is a suggested framework for businesses and legal practitioners to begin to think about how venture backed small businesses, who would otherwise be eligible to participate in the PPP, may be able to take advantage of the program without violating the letter or the spirit of the program.
Unfortunately, as with many matters that are new and cutting edge, and with rough contours (and, as of the date of this writing, this one has a lot), the question of whether or not this framework will work—from a business and/or legal perspective—is unknowable. Accordingly, we are not offering this framework as a ‘silver bullet’ of any kind, or offering any legal advice to any party, with respect hereto. The truth is, we just don’t know.
However, we are hopeful that this framework will spark a conversation around creative ways to address these roadblocks, which may, or may not, include some mixture of the foregoing techniques. We posit that it is likely that a framework that is workable for investors, businesses, counsel, the SBA and the US Treasury will be rolled-out, and likely in the next 3-4 weeks, at most. The stakes are too high for these parties not to work together.
We would suggest that the most robust (and still most likely) solution to this issue is for the Treasury and SBA to issue the necessary amendments, waivers or modifications of the regulatory framework. However, if this does not occur, then we fully expect that industry will find one or more solutions to fit quality, investor backed small businesses into the definitional framework of the PPP.
In the days and weeks to come, if we do not see a systemic fix to these issues—which, at present, are working to exclude a huge and hugely important sector of the US small business ecosystem—we will be developing and rolling out suggested documents for our clients who may be able to take advantage of these techniques. At such time, we will also make those documents publicly available, to the extent that it is prudent and helpful to do so.
In the meantime, we welcome all inquiries from businesses who may potentially benefit by participation in the PPP and are looking for forward pathways, and, of course, any and all constructive criticism from industry on the usability of the foregoing framework.
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Dated April 7, 2020
Written by Jeff Bekiares, Ed Khalili and Stan Sater
If you are a business that has questions about the Paycheck Protection Program (PPP) and how the laws impact your business, contact our Founders Legal team at [email protected], [email protected], or [email protected].