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CARES Act Update: Paycheck Protection Program & "Affiliates"

The U.S Small Business Administration ("SBA") has instituted a loan program known as the Paycheck Protection Program ("PPP"), which authorizes $349 billion in forgivable loans to small businesses to pay their employees during the current coronavirus pandemic. Small businesses impacted by coronavirus/COVID-19 hardships between February 15, 2020 and June 30, 2020 may apply for such relief through June 30, 2020.

The CARES Act expanded the availability of the SBA's "7(a) program loans" under the new PPP, and 7(b)(2) economic injury disaster loans to businesses with 500 employees or less. This includes small businesses, sole proprietors, S Corporations, C Corporations, LLCs, independent contractors, self-employed people and private non-profits. Further, companies with fewer than the number of employees the SBA has designated as the size standard based on the company's applicable 6-digit North American Industry Classification System (NAICS) code may also be eligible.

"Affiliates" Under the SBA 7(a) Program

In determining whether a company meets the 500-employees size test, the SBA aggregates the company and its "affiliates." The Interim Regulations issued April 3, 2020 provide that the affiliation rules applicable to the PPP loans will be the same as those that have applied to other "Business Loans" under the SBA's Section 7(a) program. Affiliation is defined broadly and is based on control or the power to control and includes companies under common control.

As a basic rule, ownership of 50% or more of the voting securities of a business will constitute control based on ownership alone and thus trigger affiliation between the business and its majority owner. Note, a minority stockholder will be deemed to be affiliated with the company if it has the ability to prevent a quorum or otherwise block board or stockholder actions.

If the CEO (or other officers, managing members, or partners who control management of the company) also controls management of another company, the companies are affiliates. Also, if a single entity that controls the board or management of a company also controls the board or management of another company, the companies are affiliates. Also, an entity that controls the management of a company through a management agreement is an affiliate.

Finally, in determining whether affiliation exists, "all connections between the company and a possible affiliate can be considered." Even though no single factor is sufficient to constitute affiliation, affiliation may be found "where there is clear and convincing evidence based on the totality of the circumstances." However, it must be noted that each application is determined on a case-by-case basis taking into account the facts and circumstances thereof. Further, because of the evolution of the situation, it is difficult to predict how the SBA will apply the affiliate rules.

With respect to 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.

Startups, by definition, tend to have far fewer than 500 employees. But in the existing framework of the SBA's 7(a) program, startups backed by venture capital firms may be required, in their application for a PPP loan, to count both their own employees and those of the VC firm and its other portfolio companies. That could push the employee count of the startup's PPP loan application over 500 – effectively disqualifying it. As a general rule, though, such "affiliation rules" only apply if the VC firm owns more than 50% of the startup or if it exerts operational control over the startup.

But what if several VC firms own a combined 50% or more of the startup? Would that count as an affiliation? Existing SBA rules were not clear, but the Treasury released a modified set of rules for the PPP on April 3, 2020. that generally, suggests several VC firms owning a majority of a startup's equity does not make the startup their affiliate. In this situation, a qualified startup is eligible for a PPP loan.

Paycheck Protection Program Overview

The following provides a synopsis of the PPP. For more details please see the attached fact sheet from the Department of the Treasury.

For businesses that continue to operate and retain employees over the period of February 15, 2020 and June 30, 2020, the SBA can provide a maximum loan of two months of the average monthly payroll costs during that period, plus an additional 25%. If you are in business over the period from February 15 to June 30, you will receive a maximum loan amount that is 2.5 times your average monthly payroll expenses over that time period. If you are a seasonal worker over the period from March 1 to June 30, you will receive a maximum loan amount that is 2.5 times your average monthly payroll expenses for that shortened time period. If you were not in business after February 15—that is, if you were not open because of the crisis or you went out of business entirely—you will receive a maximum loan amount that is 2.5 times your average monthly payroll expenses for the two months of January and February.

Eligible payroll expenses for calculating PPP loan amounts include:

  • Compensation (salary, wages, commission, or similar compensation, cash tips, etc.)
  • Payment for vacation, family, medical, and sick leave
  • Allowance for employee dismissal or separation
  • Payment for group health-care benefits, including insurance premiums
  • Payment of employee retirement benefits
  • Payment of state and local taxes imposed on the compensation of employees

However, the PPP does not count the following expenses when calculating the total PPP reimbursement amount:

  • Any compensation over $100,000 per employee
  • Taxes imposed under chapters 21 (payroll taxes), 22 (railroad taxes and retirement benefits), and 24 (income taxes withheld on wages) of the Internal Revenue Code (IRC)
  • Compensation of employees whose principal place of residence is outside the United States
  • Qualified sick and family leave for which a credit is already allowed under other sections (i.e., 7001 and 7003) of the Family First Coronavirus Response Act
  • Loans used for duplicate purposes of another SBA loan program already claimed by the applicant

Once an eligible small business or contractor receives the loan, they may use it for the following:

  • Payroll costs
  • Costs related to the continuation of group health-care benefits during periods of paid sick, medical, or family leave and insurance premiums
  • Employee's salaries, commissions, or similar compensation
  • Payments of interest on any mortgage obligations (not including prepayment fees or payment of principal on the mortgage itself)
  • Rent (including rents under a lease agreement)
  • Utilities

Notably, the SBA will fully forgive all loans under the PPP provided three requirements are met:

  • Loans are used exclusively for their intended purposes (see bullet points directly above)
  • Loans are used to offset no more than eight weeks (the maximum amount of time payroll expenses would be fully offset) of eligible payroll expenses
  • Businesses retain employees at salary levels comparable to before the crisis

For any amount of the loan used that does not meet the above criteria, businesses will have to repay the SBA.

The Paycheck Protection Program provides businesses with a maximum repayment window of 10 years with a top interest rate of 4 percent, without loan fees or prepayment penalties. SBA will issue regulations to ensure that any fees remain capped.

To be approved for loan forgiveness, businesses must contact their lender and submit an application including documentation verifying the number of employees on payroll and their compensation levels, along with all relevant documents showing payments on mortgage interest and utility payments. All current SBA 7(a) lenders are eligible lenders for PPP, and the U.S. Department of Treasury is responsible for authorizing new lenders.