On April 3, 2020, the Small Business Administration (SBA) issued guidance on affiliation rules, but it did not provide any of the relief that the private equity and venture capital industry was hoping for. This Alert highlights crucial points and initial observations on the guidance. A second Alert will follow with more detailed analysis.   

Highlights from the Rule and Guidance

Do the affiliation rules apply to your business?  

Yes, except for the following businesses, for which the rules in Section 121.103[1] do not apply. This includes: (1) businesses with an NAICS code beginning with 72 and that have more than 500 employees; (2) any business operating as a franchise; (3) businesses that receive financial assistance from an SBIC lender; and (4) as a result of the April 3 guidance, faith-based organizations are exempt from the application of any SBA affiliation rules.

Why do the affiliation rules matter?

If the affiliation rules affect your business, you may exceed the employee limitation eligibility requirements for a Paycheck Protection Program (PPP) loan. The affiliate tests are fact specific and you should review with your advisor when determining your eligibility for a PPP loan.

How do the affiliation rules affect your business’ ability to apply for a PPP loan?

• Prior to the CARES Act, 501(c)(3) nonprofit organizations were not eligible for SBA loans under section 7(a) of the Small Business Act.  The CARES Act allows these organizations to be eligible for PPP, but also subject to the affiliation rules under 13 C.F.R. § 121.103. 
• All other businesses must use the affiliation rules in 13 C.F.R. 121.301 to determine eligibility for a PPP loan.

What are the tests to determine if a business has an affiliate? 

• 50% or More Ownership: Two or more companies are affiliated if the same person or entity owns or has the power to control more than 50% of the applicant’s voting equity. If no person or entity owns or has the power to control more than 50% of the voting equity of a company, then the SBA will deem the board of directors or most senior officer, such as the CEO or the president, to be in control of the concern.
• The Present Effect Treatment: Treatment of outstanding stock options, convertible notes, purchase agreements and even a letter of intent are treated as if they have been exercised and/or consummated. This is contrary to typical rules of construction where stock options and convertible noteholders are not treated as “stockholders” for general corporate purposes unless they have exercised or converted such securities, as well as requiring consummation of agreements for corporate actions.  Agreements to open or continue negotiations towards the possibility of a merger or sale of stock are not given present effect. 
• Common Management: Companies may be affiliated when one or more officers, managers or directors of one company holds a controlling position in the other(s) (such as a person serving as the CEO of one company and the president of another). Affiliation also may arise where a single individual, concern or entity controls the management of a business through a management agreement. In addition, negative control rights should be reviewed, including veto rights over certain corporate actions that may be set forth in a certificate of incorporation, by-laws or a shareholder agreement. The affirmative/negative control factor requires a fact specific analysis of a company’s organization documents, agreements with stakeholders and day-to-day operations. 
• Identity of Interest 
  • Relatives: Affiliation arises when there is an identity of interest between close relatives, as defined in 13 CFR §120.10, with identical or substantially identical business or economic interests (such as where the close relatives operate concerns in the same or similar industry in the same geographic area). Where SBA determines that the interests of relatives should be aggregated, an individual or firm may rebut that determination with evidence showing that the interests are in fact separate.
  • Sharing of Resources: Also, there may be affiliation when concerns share resources, employees, equipment, office space or do business with each other, even if they don’t meet the other affiliation tests. 
  • Economic Dependence: The “economic dependence” test requires affiliation when a business receives 85% of its receipts over the past three fiscal years from a contractual relationship with another concern, unless (a) the contract does not restrict the concern from selling the products or services to another purchaser or (b) the SBA agrees that the terms of the contract do not provide the purchaser with the power to control the seller. 
• Totality of Circumstances: Regardless of the application of the above tests and rules, the facts and circumstances can suggest that businesses are closely intertwined and in such circumstances, they may be deemed affiliated. 

About Duane Morris

Duane Morris has created a COVID-19 Strategy Team to help organizations plan, respond to and address this fast-moving situation. Contact your Duane Morris attorney for more information. Prior Alerts on the topic are available on the team’s webpage. 

For Further Information

If you have any questions about this Alert, please contact Nanette C. Heide, Sandra G. Stoneman, any member of the COVID-19 Strategy Team or the attorney in the firm with whom you are regularly in contact.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.