Venture-Backed Startups Can Access SBA 7(a) Loans — What The Experts Won’t Tell You!

“Dear Ed:

I’m panicking – I’ve read the guidance published by industry experts – they all seem to agree that venture capital backed startups like my company are ineligible for the new SBA 7(a) loans because somehow I have a “affiliate” of my VCs and all their other startups. I don’t even know what that means and I really need the $$ right now to keep our startup afloat. Help!

Sascha Startup”

Before I continue – there really isn’t one Sasha Startup. However, Sasha is a mix of countless emails, text messages and phone calls that my fellow law firm (see Disclosure) and I have been handling over the past week. I am pleased to be the bearer of the GOOD news in this regard. Please read on to clear up the confusion that venture-funded startups are somehow almost complete lock out of the new SBA Section 7(a) Loans. Spoiler alert – they’re not! (link to longer footnote column that my colleagues and I have published earlier this week).

The CARES Act (March 27, 2020) introduced a new type of loan program known as the Paycheck Protection Program (the PPP) within the US Small Business Administration’s (SBA) Section 7(a) Loan Program. The startup/VC community read the SBA’s arcane rules on “affiliates” and concluded that pretty much any startup would not be eligible because, as one observer put it (paraphrased):

“Most of the attorneys I spoke to read the affiliate provision in the CARES Act to mean that any venture capital-backed startup would have to affiliate with all other startups in that VC’s portfolio.”

If this were correct (it isn’t), it would present a problem: Most companies that (together with their “affiliates”) have more than 500 employees do not qualify for SBA Section 7(a) loans Question. So the question is, when do the “affiliate” rules force you to “aggregate” with your VC’s other portfolio companies (and the VCs themselves) to determine if you have 500 employees?

There are two different rules that explain how to determine whether SBA considers companies to be “affiliated companies”.

The early guidance focused on the wrong rule.

That wrong rule is 13 CFR §121.103. It’s a generally applicable rule, however it is not the rule that governs Section 7(a) Loans.

The rule that governs SBA Section 7(a) loans is actual 13 CFR §121.301. I have dyslexia (really), so I hate that there is a Section 301 and Section 103, both of which define “affiliate” for SBA programs.

However, applying Section 301 instead of 103 matters a lot!

Section 103(c)(2) (the WRONG section). belonging where multiple VCs each own significant portions of a startup’s stock and collectively “control” that startup, even if none of them owns the majority. In these cases, the SBA will “assume” that each VC “controls or has the authority to control” if:

“two or more people [VCs] … each of them owns, controls or is authorized to control less than 50 percent … and such minority interests are equal or approximately equal, and the sum of such minority interests is large compared to any other equity interest…”

In contrast, Section 301 — (the RIGHT-WING section) which actually governs SBA 7(a) loans — has no analog to this portion of Section 103. Therefore, for Section 7(a) loans, startups do NOT need to find “belonging” based on two or more shareholders with approximately equal shares that together are “large” compared to others. Instead, Section 301 deals with the power of “control” held by a Shareholder (and not a group of unaffiliated minority shareholders) if that shareholder “owns or has the power to control more than 50 percent of [company’s] Voting Capital.” That’s a really big difference, and Very few VCs own more than 50% of a startup (Typically, a VC fund owns a minority, not a majority, stake in a startup).

The analysis does not end here. Both Section 103 and Section 301 also state that there are controls that allow a shareholder to block corporate actions (in other words, the protective provisions or veto rights on venture deals) that could trigger a determination of “control,” which could result in the SBA concluding that the VC is a “affiliate.”

The final result: Answer these three questions to determine the suitability of your VC-backed startup:

(1) your VC holds 50% or more of your startup’s equity (calculated under section 301(f)); or

(2) even if not, a single VC controls a majority of the startup’s board; or

(3) even if not, an individual VC controls significant safeguards that allow that VC to block meaningful corporate actions, such that the VC controls the start?

If you answer yes to ANY a For the above questions, please consult an attorney as you may then need to add your employee count to that of your VC and any other ‘subsidiaries’ of that VC.

If you answered no to all three questions, that’s probably good news (talk to the attorney anyway). Many US-based startups WILL qualify for SBA Section 7(a) loans, despite the early announced negative outlook on the subject.

There are more details in the longer, nerdy, footnoted article my colleagues (Matthew Moisan, Kimberly E Lomot, Lowell A. Citron, Ray Thek) and I was a co-author.

Please – if your business needs cash, and so many currently do – find an SBA lender (here’s a link to SBA List of 100 Most Active (7a) Lenders) and apply!

Good luck and stay healthy.

PS: The SBA has not changed the laws in the last few days. Both sections 103 and 301 as written well before the pandemic, you say that Section 301 governs the “affiliated” and “control” provisions for Section 7(a) SBA loans.

DISCLOSURE: I am a partner in the law firm Lowenstein Sandler LLP. Although we advise many startups, growth companies and funds, this column is NOT legal advice, so check with your attorney. Also, this column is NOT intended to encourage applicants to complete the application in any way that is untruthful/inaccurate.

Resources/Notes:

Of Matthew J Moisan, Ed Zimmerman, Lowell A. Citron, Kimberly E Lomotand Raymond P. ThekSBA Section 7(a) Loans for venture capital backed growth companies/start-ups under the CARES ActLowenstein Sandler LLP (March 31, 2020).

Lowell A. Citron, Michael A. “Bux” Buxbaum, Theodore C. Sicaand Kimberly E LomotSBA Paycheck Protection Program‘, Lowenstein Sandler LLP (March 29, 2020).

Twitter thread here.

For those who want to see that this is already firmly established in law: See 13 CFR §121.103(a)(8) (“For applicants in the SBA’s Business Loan, Disaster Loan and Surety Bond Guarantee programs, the Sizing Standards and Basics for affiliation are set forth in §121.301.”); and 13 CFR §121.301(f) (“Affiliation in any of the circumstances described below is sufficient to establish affiliation for SBA business loan applicants. … For this rule, the business loan programs consist of the 7(a) loan program …” ). See also, SBA Small Business Compliance Guide: Size and AffiliationJune 2018 (“For the SBA’s Business Loan, Disaster Loan, and Surety Bond programs, the affiliation rule is found at 13 CFR §121.301(f). The Business Loan Programs consist of the 7(a) Loan Program … differences in treatment of affiliation to these programs are indicated below.”). The SBA guidance does not fully describe the differences between Section 301 and Section 103.

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