Disclaimer: This post discusses general legal issues, but it does not constitute legal advice in any respect. This post is not a substitute for legal advice and is intended to generate discussion of various issues. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel. Cara Stone, LLP. and the author expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post. The views expressed herein are personal opinion.

In the rush to pass an economic stimulus package, house and senate leaders have left the issuance of small business loans to the Small Business Administration (the “SBA”). The problem, however, is that the SBA generally does not handle matters for angel or venture-backed business (or, for that matter, businesses with a lot of equity investment).

The SBA “affiliation” and guaranty rules could significantly complicate the ability of angel or venture-backed companies from obtaining any loan relief under the current package unless the regulations that accompany the legislation actually provide guidance on this issue. Several venture and angel capital groups are currently working to change the legislation. Here are the primary challenges:

  1. Affiliation rules. Current SBA guidance on affiliation will require that VCs and angel funds aggregate portfolio companies’ employees and revenues, which could substantially complicate eligibility for startups. “Generally, affiliation exists 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. Control may arise through ownership, management, or other relationships or interactions between the parties. SBA’s regulations on affiliation are contained in 13 C.F.R. §’103. Where affiliation exists, the SBA looks at the affiliates businesses to determine eligibility, so companies may have their eligibility denied if they are aggregated with other portfolio companies, or they could face delay if they must rebut the presumption of affiliation with other portfolio companies of their investors.
  2. SBA currently looks at the following factors to presume “affiliation” of related businesses (meaning it will find affiliation absent a finding otherwise):
    1. Control of 50% or more of voting stockif anyone controls 50% or more of the equity of the company, that person will be expected to personally guaranty a loan.
    2. Control of less than 50% voting stock, but large compared to othersif any investor has a relatively large voting block when compared to other owners, that investor may be deemed to be an affiliate.
    3. Control of 50% voting stock by multiple minority owners—if 2 or more persons owns or controls less than 50% of the voting stock and (i) minority shareholders own approximately the same amount and (ii) all minority holdings taken together are large compared to others, then each of those minority holders may be considered to be affiliates. In other words, all of your investors might be aggregated, and each could be considered to be affiliated.
    4. Widely Held Voting Stock—if the stock is widely held with no voting block is sufficient to wield power, then the CEO and Board are considered to be in control, and any business controlled by a board member, the CEO or president is presumed to be an affiliate of the applicant business.
    5. Stock Options, Convertible Notes—SBA will treat all of these as having been exercised or converted (even if they are still just options or convertible notes.
    6. Board and/or Shareholder Controls—SBA presumes affiliation of board members’ and/or stockholders’ businesses where those board members or stockholders have major decision veto rights or occupy the majority of the board seats on a company. Most angel and VC deals give these types of rights to investors, and investors quite often occupy the majority of the seats on the board. These factors could result in SBA presuming affiliation and requiring aggregation of those investors/board members’ other businesses when analyzing eligibility for a loan.

Various investor organizations are working on proposals to have these issues waived for loans under the pending legislation, and various groups are discussing how/whether/if they can get either legislative or regulatory clarification of these issues as they affect VC-backed or angel-backed companies.

Before your angel or VC-backed companies rush to file an application, your board is wise to consider changes to the board structure, investment terms and keep abreast of clarifications to avoid delay and denial of critical capital that becomes available during the crisis.

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