SBA Affiliation Rules May Affect COVID-19 Economic Relief Efforts

Within days of President Trump signing the Coronavirus Aid, Relief, and Economic Security (CARES) Act, small businesses are racing to obtain relief from the impact of COVID-19 through the Paycheck Protection Program (PPP) in the form of a forgivable Small Business Administration (SBA) loan.

The SBA generally defines a small business as one with less than 500 employees. However, due to something called “affiliation rules” – which are extremely nuanced and govern these loans – certain companies may not qualify.

What are the affiliation rules and how do they apply?

At a high level, the affiliation rules exist when one business controls or has the power to control another, or when a third party (or parties) controls or has the power to control both businesses. This means companies backed by investors, for example, must count those company’s employees as their own, often making companies exceed the 500-employee threshold. Understanding the affiliation rules and how to navigate them is important when a business has a dynamic or diverse ownership structure. Most commonly, this would be companies controlled, at least in part, by private equity firms, venture capital firms, hedge funds, or other entities. An individual business may have less than 500 employees, but based on the businesses’ ownership structure, the business may not meet the SBA’s criteria for a small business.

The SBA affiliation rules are cumbersome. Where should I focus my attention?

As previously stated, affiliation exists when one business controls or has the power to control another, or when a third-party controls or has the power to control both businesses. With that in mind, here are two important concepts to take into consideration when defining control:

• Stock ownership/financial control (affirmative) – As a baseline, control of 50% or more of voting stock by an investor would trigger affiliation consideration. Fully diluted ownership should be considered when reviewing this standard. Options, convertible securities, and agreements to merge should be treated as though they have been exercised. Not only that, ownership control can be deemed if a minority owner owns or has the power to control a block of stock that is large compared to others.

• Non-financial control (negative) –The stock ownership standard does not necessarily need to be triggered should the company or any individual have negative covenant issues regarding day-to-day control, certain veto rights, or other controlling aspects available to a minority investor. These bright-lines apply whether or not the applicable power is exercised.

In all, the SBA and your lender will consider the totality of the circumstances when determining whether affiliation exists and may find affiliation based on the totality of the circumstances even though no single factor alone may be sufficient to constitute affiliation.

I thought certain small businesses are now excluded from the SBA’s affiliation rules for the PPP?

That’s correct. Certain entities are exempt from these affiliation rules for the PPP:

• Any business with fewer than 500 employees per physical location of the business and that is assigned a NAICS code beginning with 72 (Accommodation and Food Services).

• Businesses operating as a franchise that are assigned a franchise identifier code by the SBA.

• Businesses that receive funding through a Small Business Investment Company (SBIC).

I think I have a potential affiliation issue. How do I calculate the applicable employees?

Add the average number of employees of your business with the average number of employees of each affiliate. Additional items to note:

• If a business has acquired an affiliate or has been acquired as an affiliate during the applicable period of measurement or before the date on which it self-certified as small, the employees counted in determining size status include the employees of the acquired or acquiring business.

• If a business was sold or ceased operations before the date used for determining size, those employees would not be included in the calculation.

We still aren’t sure if the rules apply to us. What should we do from here?

Many organizations and influencers are lobbying for the existing SBA affiliation rules to be amended or waived. While we wait for clarity, the prudent next step would be to begin the application process for COVID-19 relief through the SBA’s Economic Injury Disaster Loan and the CARES Act’s PPP.

If you have questions, comments, or concerns, please reach out to your KSM advisor or complete this form.

Visit the KSM COVID-19 Resource Center