Information regarding the affiliate rules that can impact access to the Small Business Administration (SBA) Paycheck Protection Program (PPP) under the CARES Act for our venture capital-backed clients is complex. Although more formal guidance will be forthcoming, we wanted to share our current thoughts.
KEY CONSIDERATIONS: We are concerned that guidance to date regarding the CARES Act effectively makes the relief meaningless to many (if not most) of our venture capital-backed clients ABSENT a current agreement between the company and its venture fund investor(s) to amend existing stockholder or special board designee voting rights to the extent such rights offer the investor blocking or control powers. Of course, the decision whether or not to amend will need to be made jointly by the company and its investor(s), weighing the competing benefits of the PPP to the company and the stockholder or the board designee voting rights to the investor(s).
GUIDELINES: Here are some basic guidelines that likely will be helpful:
- An investor with greater than 50% ownership is an affiliate (calculate this on a partially fully-diluted basis in which the “offending” investor’s ownership is determined by a fraction, the numerator of which is the sum of the investor’s shares plus presently exercisable equivalents (options/warrants to the extent currently exercisable and in-the-money) and the denominator of which is all outstanding shares plus all presently exercisable and in-the-money equivalents).
- A single investor with a specific right to block a quorum of the board or of stockholders is an affiliate, regardless of its ownership percentage.
- An investor with the ability to block certain operational or business actions, whether through a stockholder protective provision or a special board designee voting right, is an affiliate, regardless of ownership percentage. Here, a stockholder-level veto in a protective provision or a director-level blocking/voting right (such as “approved by the board, including the [designated] director”) is likely to create an affiliate issue but only if limited to a specified stockholder or investor board designee, rather than to all members of a class of stock or to all investor board designees. In other words, the blocking right has to be available to/exercisable by a single investor as a stockholder or board designee.
SAMPLE PROVISIONS LIKELY TO BE DEEMED TO BE BLOCKING: Here are sample protective stockholder or board voting provisions likely to be deemed to create control or blocking rights:
- Payment of dividends/distributions
- Ability to establish a quorum of stockholders or the board
- Determining employee compensation
- Ability to hire/fire executives
- Establishing/amending incentive/employee stock ownership plans
- Broadening power to block any changes in the company’s strategic direction
- Committing any act that would alienate or encumber the company’s assets
- Amending or terminating existing lease agreements
- Buying equipment
- Incurring debt or other obligations
- Changing the budget
- Bringing/defending lawsuit(s)
SAMPLE PROVISIONS UNLIKELY TO BE DEEMED TO BE BLOCKING: Here are sample protective stockholder or board voting provisions unlikely to be deemed to create control or blocking rights:
- Selling all or substantially all of a company’s assets
- Mortgaging or placing an encumbrance upon all or substantially all of a company’s assets
- Engaging in any action that could result in a change in the amount or character of a company’s contributions to capital
- Issuing additional stock or equity
- Approving an increase or decrease in the number of the company’s authorized interests, or reclassifying interests
- Changing the character of a company’s business
- Amending a company’s charter, bylaws, operating agreement or similar governing documents
- Taking an action in contravention of a company’s charter, bylaws, operating agreement, or similar governing documents
- Disposing of the company’s goodwill
- Committing any act that would make it impossible for the company to carry on its ordinary course of business
- Submitting a company’s claim to arbitration
- Entering into a confession of a judgment
- Entering into substantially different lines of business
- Adding new members
- Dissolving the company
- Approving an increase or decrease in the size of the company’s board of directors or other governing body
- Filing for bankruptcy
RESOLUTION: While guideline 1 is purely arithmetic, with respect to guidelines 2 and 3, venture capital clients and venture capital-backed company clients desiring to gain access to the benefits of the PPP should consider removing the “block” with a charter amendment or other amendment to the definitive transaction document (or side letter agreement, if applicable) to eliminate the provision that creates the affiliate issue that, in turn, precludes access to the PPP.
IMPACT OF CONVERTIBLE NOTES AND SAFES: We have received many questions from clients regarding the applicability of convertible notes and SAFEs to the affiliate rules. Currently, we believe that convertible notes and SAFEs are disregarded, absent either (1) control provisions in the notes or SAFEs (which, in our experience, are unusual) or (2) optional conversion rights (which often are in place).
LOAN APPLICATION: With respect to completing the loan application, we also are receiving questions about disclosures relating to 20% or more holders. We recommend, assuming, of course, there are no affiliate issues based on the guidelines above (including when the company and its venture investor(s) have acted as noted above to eliminate the offending provision(s)), considering disclosure such as the following:
With respect to “Applicant Ownership” certain investment funds affiliated with [Fund] (collectively, “Fund”) together own, as of the date of the Application, a greater than 20% ownership stake in the Applicant. However, as of the date of the Application, Fund does not own 50% or more of the Applicant’s voting securities. Furthermore, as of the date of the Application, under the Applicant’s charter or bylaws or pursuant to a stockholders’ or other agreement, Fund, alone, does not have the right to prevent a quorum or otherwise block action by the board of directors or shareholders as determined pursuant to 13 CFR § 121.301 (the “Applicable Affiliation Rules”). The Applicant has further determined that Fund is not an affiliate of the Applicant under the Applicable Affiliation Rules. In light of the fact that the Applicant has determined that Fund is not an affiliate under the Applicable Affiliation Rules, no further information regarding Fund or the relationship between Fund and the Applicant is being provided with the Application.
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