How to Determine Eligibility Under SBA Affiliation Rules for the CARES Act Paycheck Protection Program

Under the CARES Act, approximately $350 billion in forgivable loans for small businesses is available through the Paycheck Protection Program (PPP). Loans issued through the PPP are designed to provide a direct incentive for small businesses to keep their workers on the payroll. Under the PPP, loans of up to $10 million can be used to cover payroll, paid sick leave, insurance premiums, rent, utilities and mortgage payments. If a company retains its full staff and payroll, all of its eligible expenses for up to eight weeks will be 100% forgiven. A company can apply through any existing SBA 7(a) lender or through any federally insured depository institution, federally insured credit union and Farm Credit System institution that is participating. Lenders began processing applications on April 3, 2020 and the PPP will run through June 30, 2020.

To be eligible under this program, entities must have 500 employees or less, or meet the SBA’s industry-based “size standard” requirements for the applicable NAICS code (based either on number of employees or annual receipts). In determining size, the standard SBA affiliation rules apply, except that the CARES Act waives the 500 employee size limitation for businesses in the food service and hospitality industries, SBA-approved franchises, and businesses that receive financial assistance from Small Business Investment Company (SBIC) funds. The affiliation rules may pose challenges for companies that have venture capital or private equity investors. If a small business can make a good faith claim that, based on the application of the existing affiliation rules, it meets the CARES Act size standard, it should provide its lender with all relevant information and allow the lender to make the call. In the small business loan program, the SBA will typically defer to the conclusion of the lender as long as there is a good faith basis for concluding the entity meets the size standard and that affiliation does not exist.

The SBA continues to issue new guidance on the PPP. This overview provides guidance based on information currently available from the SBA regulations, the SBA’s interim final rule, the SBA’s General Counsel Letter and the SBA’s FAQs document. ¹

What Is the Applicable Size Standard?

Businesses have the option to choose between three different size standards to determine size eligibility under the PPP. The CARES Act provides a 500 employee size standard, which a business may use regardless of whether the applicant qualifies as a small business under SBA’s two existing size standards.

In the alternative, a PPP applicant will also be eligible if it satisfies the existing statutory and regulatory definition of a “small business concern” under Section 3 of the Small Business Act, 15 U.S.C. 632. This means a business can qualify if it meets the SBA employee-based or revenue-based size standard corresponding to its primary industry. Thus, small businesses in industries with size standards that exceed 500 employees may use the higher SBA size standards.

A business will also be eligible as a small business if it meets the SBA’s “alternative size standard” test, which requires that: (1) maximum tangible net worth of the business is not more than $15 million; and (2) the average net income after federal income taxes (excluding any carry-over losses) of the business for the two full fiscal years before the date of the application is not more than $5 million.

How Do You Calculate the Number of Employees?

The standard SBA employee calculation rule applies to eligibility under the PPP. Although the CARES Act makes reference to a “covered period” (the period beginning on February 15, 2020, and ending on June 30, 2020), this period defines the period of time in which companies are eligible to receive covered loans, not the period of time to calculate the number of employees. The SBA sets forth the following rules to determine a business’s number of employees:

• SBA counts all individuals employed on a full-time, part-time or other basis.
• If the size standard is number of employees, the method for determining size is the average number of employees of the business (including the employees of its domestic and foreign affiliates) based upon numbers of employees for each of the pay periods for the preceding completed 12 calendar months. If a business has not been in business for 12 months, the average number of employees is used for each of the pay periods during which it has been in business. 13 C.F.R. § §121.106(b).
• The rules specify that the average number of employees of a business with affiliates is calculated by adding the average number of employees of the business with the average number of employees of each affiliate.
  • If a business has acquired an affiliate or 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. This aggregation applies for the entire period of measurement, not just the period after the affiliation arose.
  • The employees of a former affiliate are not counted if affiliation ceased before the date used for determining size. This exclusion of employees of a former affiliate applies during the entire period of measurement, rather than only for the period after which affiliation ceased. However, if a business has sold a segregable division to another business during the applicable period of measurement or before the date on which it self-certified as small, the employees used in determining size status will continue to include the employees of the division that was sold.

The SBA’s guidance also suggests that businesses may calculate their average employment over the same time period used to calculate their aggregate payroll costs. The SBA has stated that, in general, borrowers can calculate their aggregate payroll costs using data either from the previous 12 months or from calendar year 2019. For seasonal businesses, the applicant may use average monthly payroll for the period between February 15, 2019, or March 1, 2019, and June 30, 2019. An applicant that was not in business from February 15, 2019 to June 30, 2019 may use the average monthly payroll costs for the period January 1, 2020 through February 29, 2020.

When Does Affiliation Exist?

For purposes of the determining the number of employees of an applicant to the PPP, the applicant is considered together with its affiliates, unless an exception or waiver applies. The SBA regulations provide that entities are affiliates of each other when one controls or has the power to control the other, or a third party or parties controls or has the power to control both. Whether or not control is exercised is irrelevant, so long as the power to control exists. Control may arise through ownership, management, or other relationships or interactions between the parties. See 13 C.F.R. §121.301(f).

The SBA issued additional guidance on the applicability of this loan program and the applicable affiliation rules.² The CARES Act only references 13 C.F.R. § 121.103; however, the recent SBA guidance clarifies that the detailed affiliation standards contained in section 121.103 of the SBA regulations currently do not apply to PPP borrowers, because section 121.103(a)(8) provides that applicants in SBA’s Business Loan Programs (which include the PPP) are subject to the affiliation rule contained in 13 CFR § 121.301.³ The guidance appears to narrow the scope of the applicable affiliation rules, identifying only four tests based on control that apply to participants in the PPP. The SBA has indicated that lenders are not required to make an independent determination regarding the applicability of affiliation rules under 13 CFR § 121.301 to borrowers. Instead, it is the business’s responsibility to determine which entities (if any) are affiliates and determine the total number of combined employees. Lenders are permitted to rely on borrowers’ certifications.

• Affiliation based on ownership
  • For determining affiliation based on equity ownership, a concern is an affiliate of an individual, concern or entity that owns or has the power to control more than 50% of the concern's voting equity. If no individual, concern or entity is found to control, SBA will deem the board of directors, president or chief executive officer (CEO) (or other officers, managing members or partners who control the management of the concern) to be in control of the concern. SBA will deem a minority shareholder to be in control, if that individual or entity has the ability, under the concern's charter, by-laws or shareholder's agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders. 13 C.F.R. § 121.301(f)(1)
  • If a minority shareholder in a business irrevocably waives or relinquishes any existing rights specified in 13 C.F.R. 121.103(f)(1) (the right to prevent a quorum or otherwise block action by the board of directors or shareholders), the minority shareholder would no longer be an affiliate of the business (assuming there is no other relationship that triggers the affiliations rules).
• Affiliation arising under stock options, convertible securities and agreements to merge
  • In determining size, SBA considers stock options, convertible securities and agreements to merge (including agreements in principle) to have a present effect on the power to control a concern. SBA treats such options, convertible securities and agreements as though the rights granted have been exercised.
  • Agreements to open or continue negotiations toward the possibility of a merger or a sale of stock at some later date are not considered “agreements in principle” and are thus not given present effect.
  • Options, convertible securities and agreements that are subject to conditions precedent which are incapable of fulfillment, speculative, conjectural or unenforceable under state or federal law, or where the probability of the transaction (or exercise of the rights) occurring is shown to be extremely remote, are not given present effect.
  • An individual, concern or other entity that controls one or more other concerns cannot use options, convertible securities or agreements to appear to terminate such control before actually doing so. SBA will not give present effect to individuals’, concerns’ or other entities’ ability to divest all or part of their ownership interest in order to avoid a finding of affiliation.
    13 C.F.R. § 121.301(f)(2)
• Affiliation based on management
  • Affiliation arises where the CEO or president of the applicant concern (or other officers, managing members or partners who control the management of the concern) also controls the management of one or more other concerns. Affiliation also arises where a single individual, concern or entity that controls the board of directors or management of one concern also controls the board of directors or management of one of more other concerns. Affiliation also arises where a single individual, concern or entity controls the management of the applicant concern through a management agreement. 13 C.F.R. § 121.301(f)(3)
  • The SBA interim rule notes that in order to help potential borrowers identify other businesses with which they may be deemed to be affiliated under the common management standard, the Borrower Application Form, SBA Form 2483, requires applicants to list other businesses with which they have common management. The information supplied by the applicant in response to that information request should be used by applicants as they assess whether they have affiliates that should be included in their number of employees reported.
• Affiliation based on identity of interest
  • 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 interests should be aggregated, an individual or firm may rebut that determination with evidence showing that the interests deemed to be one are in fact separate. 13 C.F.R. § 121.103(f).

As noted in the summaries above, the SBA has some discretion in determining control. SBA will consider the totality of the circumstances and may find affiliation even though no single factor is sufficient to constitute affiliation. 13 C.F.R. § 121.301(f)(6). It is important to remember that the affiliation determination is not an exact science. It is a very fact specific, case-by-case inquiry. The SBA looks at the totality of the circumstances and exercises subjective judgment in determining whether sufficient control exists to create affiliation. Consider the following points when analyzing control of a company:

• Control may be negative or affirmative
• A minority shareholder may be found to have sufficient power to exercise negative control over a challenged concern through its ability to exercise a veto power over certain corporate actions, even though the minority shareholder lacks the affirmative ability to approve actions. Size Appeal of: Dhs Sys. LLC, Appellant, SBA No. SIZ-5211 (Mar. 14, 2011); Novalar Pharm., Inc., Appellant, SBA No. SIZ-4977 (Aug. 4, 2008) (finding the ability to block decisions regarding dividends, which are important decisions in the operation of the business, constituted negative control).
• Powers held by investors which fall under the category of investor protection (such as increasing or decreasing the size of the board, reclassifying interests, or the power to veto unusual or extraordinary actions) do not constitute control of the financial resources of the company, and therefore do not result in a finding of control for purposes of the affiliation rules. Powers that go beyond what is necessary to protect the interest of minority investors, and provide the ability to exercise veto over the day-to-day operations of the company, are indicative of control. See Size Appeal of: Dhs Sys. LLC, Appellant, SBA No. SIZ-5211 (Mar. 14, 2011); Size Appeal of Carntribe-Clement 8AJV #1, LLC, SBA No SIZ-5357 (2012).

Are There Exceptions to the Affiliation Rules?

For purposes of the PPP, only three express exceptions apply to the SBA’s affiliation standards:

1. Small businesses in the hotel and food services industries (have a NAICS code beginning with 72).
2. Franchises assigned a franchiser identifier code. Notably, interested parties are still seeking additional guidance from SBA on the scope of the franchise exception.
3. Businesses that receive financial assistance from a company licensed under section 301 of the Small Business Investment Act of 1958 (15 U.S.C. 681). This waiver applies to such entities regardless of the amount of investment from an SBIC and regardless of whether there are also non-SBIC investors. Thus, despite the affiliation rules that generally apply to businesses owned in part by investment firms, if an SBIC has provided financial assistance to a business concern in any amount (including loans, debt with equity features, equity, guarantees and/or securities purchased from an underwriter), and that business is owned or controlled by one or more investment firms, all affiliation rules are waived.

Organizations may also need guidance about the applicability of the general affiliation exceptions.

• Pursuant to 13 C.F.R. 121.103(b)(1): “Business concerns owned in whole or substantial part by investment companies licensed, or development companies qualifying, under the Small Business Investment Act of 1958, as amended, are not considered affiliates of such investment companies or development companies.” This exception is in line with the exception in the CARES Act.
• The SBA affiliation rules also create an exception under 13 C.F.R. 121.103(b)(5), which states in part that, for financial, management or technical assistance under the Small Business Investment Act of 1958, a business is not affiliated with the following investors:
  • Venture capital operating companies, as defined in the U.S. Department of Labor regulations found at 29 CFR 2510.3-101(d).
  • Investment companies registered under the Investment Company Act of 1940, as amended (1940 Act).
  • Investment companies, as defined under the 1940 Act, which are not registered under the 1940 Act because they are beneficially owned by less than 100 persons, if the company's sales literature or organizational documents indicate that its principal purpose is investment in securities rather than the operation of commercial enterprises.
  *This exception is not applicable to the PPP. The PPP provides loans authorized under section 7(a) of the Small Business Act. Companies are not receiving financial assistance under the Small Business Investment Act.
• The SBA also has affiliation rules for its Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) programs. See 13 C.F.R. 121.702. The SBA amended its SBIR policy directive in 2012 to implement certain provisions of the National Defense Authorization Act for Fiscal Year 2012 affecting the program. Generally, no single venture capital operating company, hedge fund or private equity firm may own more than 50% of the concern unless that single venture capital operating company, hedge fund or private equity firm qualifies as a small business concern that is more than 50% directly owned and controlled by individuals who are citizens or permanent resident aliens of the United States. However, under the policy directive agencies may issue a certain percentage of their funding awards to small businesses that are majority-owned by multiple venture capital operating companies (VCOCs), hedge funds or private equity funds. The exception allows the National Institutes of Health (NIH), Department of Energy (DOE) and the National Science Foundation (NSF) to award not more than 25% of their SBIR funds to such small businesses. All other SBIR agencies may award not more than 15% of their SBIR funds to these small businesses.
  
  * This exception is specific to the SBIR and STTR programs and does not affect affiliation determinations for purposes of the PPP.

1. The SBA’s Frequently Asked Questions (FAQs) document expressly states that the U.S. government will not challenge lender PPP actions that conform to this guidance, and to the PPP Interim Final Rule and any subsequent rulemaking in effect at the time.
2. The interim final rule is available at: https://www.sba.gov/sites/default/files/2020-04/SBA%20IFR%202_1.pdf. The SBA’s overview of the affiliation rules is available at: https://www.sba.gov/sites/default/files/2020-04/Affiliation%20rules%20overview%20%28for%20public%29%20v2.pdf. The SBA has also issued a GC Letter on PPP and a Frequently Asked Questions document.
3. The SBA’s GC Letter on PPP indicates that applicants and lenders should refer to the pre-2020 version of 13 C.F.R. §121.301. Section 1102(e) of the CARES Act permanently rescinds an amendment that SBA issued in February. See 85 FR 7622 (Feb. 10, 2020). This means the common investment affiliation rule and the economic dependence affiliation rule do not apply to the PPP.

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