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SBA Provides Guidance on Affiliation Rules for Paycheck Protection Program

Many issues have arisen related to the Small Business Administration's (SBA) "affiliation rules" for determination of whether a small business is eligible for a loan under the Paycheck Protection Program (PPP), which is part of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act).

Since April 3, 2020, the SBA has provided guidance relating to the PPP, including guidance titled "Affiliation Rules Applicable to U.S. Small Business Administration Paycheck Protection Program," and a Letter Re: Size Eligibility and Affiliation Under the CARES Act. The SBA has also provided responses to a number of FAQs posted on the SBA's website and updated through April 7, 2020. Pursuant to this guidance, the SBA has modified the affiliation rules (which are codified 13 C.F.R. §§121.103 and 121.301, the "Rules") for purposes of determining eligibility for a PPP loan [1].

What Is a Small Business Generally?

One of the bedrock principles for SBA loans is that they are to be provided solely to "small businesses." The SBA has generally defined a small business as one with fewer than 500 employees [2]. To ensure loans are not provided to larger businesses, the SBA enacted the Rules, which aggregate the number of employees of multiple affiliated businesses (each, a "Business Concern"). Although affiliation is generally determined based on control, the Rules are encompassing and provide the SBA with significant flexibility to determine if affiliation exists under a variety of circumstances. Such flexibility permits the SBA to look beyond a Business Concern's creative structuring to determine if affiliation exists and exclude a Business Concern from meeting the SBA's definition of a small business.

In practice, the Rules have generally prevented Business Concerns backed by private equity and venture capital investors (as a majority or minority investors) from receiving SBA loans because of the multiple investments typically maintained by these investors. Given the breadth of the Rules, many Business Concerns appeared to be initially ineligible for PPP loans, and therefore, the SBA has provided additional guidance which modifies the Rules (the "Modified Rules") to permit certain Business Concerns to be eligible for PPP loans. Except as specifically addressed in the Modified Rules and the SBA and Treasury guidance with respect to the same, the Rules remain in full force and effect. Of particular importance, the SBA has opined that the Modified Rules waive the affiliation rules with respect to any Business Concern receiving financial assistance from a company licensed under §301 of the Small Business Investment Act of 1958, and such affiliation rules are waived no matter the amount of the financial assistance or whether there are other non-SBIC investors.

Modified Affiliation Rules

Although the Modified Rules are more limited in determining affiliation, the principle of aggregating the number of employees for a Business Concern that is controlled by a common entity or person (the "Presumed Owner") remains in place. Under the Modified Rules, affiliation exists, and therefore the number of employees of a Business Concern is aggregated, in the following situations:

  • Affiliation Based on Common Ownership: If the majority of equity (stock, membership interests, partnership interests, etc.) of two or more entities is owned by the Presumed Owner, then the employees of such entities will be aggregated as the same Business Concern. In the most obvious instance, this would involve a Presumed Owner that owns greater than 50 percent of the equity of one or more business entities. As noted below, however, a Presumed Owner cannot circumvent the Modified Rules by divesting its equity in exchange for options, convertible securities or similar contractual rights to ownership.

  • Affiliation Based on Control: If the Presumed Owner has contractual rights to control two or more entities (even if such rights are not exercised), then the employees of such entities will be aggregated as the same Business Concern. Mere ownership of equity is not the sole determinative factor, and a Presumed Owner that owns a minority amount (or no amount) of the equity of an entity can be determined to be in control of such entity if such Presumed Owner has potential ownership of the entity (via options to purchase equity, convertible securities or equivalent) [3] or can control the management of such entity (via contractual rights that prevent a quorum of the governing body or otherwise prevent the governing body or equity holders from controlling the direction of such entity) [4]. This determination is based on contractual rights and therefore, agreements to negotiate future acquisitions, consolidations or mergers (such as letters of intent) do not alone cause an affiliation of entities.

  • Affiliation Based on Common Management: If two or more entities are managed by common management (same governing bodies, officers, managers, directors, partners, etc.), then the employees of such entities will be aggregated as the same Business Concern. Affiliation is also determined if a Presumed Owner can control, directly or indirectly, the management of two or more entities.

  • Affiliation Based on Familial Relations: If two or more entities are owned or managed by "close relatives" [5] and have identical or substantially identical business or economic interests, then the employees of such entities will be aggregated for SBA loan eligibility purposes. Unlike the Modified Rules for control and common management, this presumption may be rebutted by a potential borrower that can show that the interests are separate (e.g., in the case of estranged parties).

Based on the guidance provided by the SBA, the Modified Rules only supersede the Rules in specific instances, such as the elimination of the economic-dependence and common-investment affiliation rules that were in effect under the Rules. The remainder of the Rules, however, including the ability of the SBA to assess size eligibility and affiliation issues based on the totality of the facts and circumstances with respect to a Business Concern, should be presumed to remain in full force and effect.

The guidance provided by the SBA has been fluid in nature and is subject to ongoing modification. Given that and the potential criminal sanctions upon borrowers that seek PPP Loans in contradiction with the Modified Rules, we recommend having an open dialogue with your lender and that you err on the side of over-disclosure in all applications relating to PPP loans. In addition, if you have heeded the SBA's advice and already applied for a loan under the PPP, you are entitled to rely upon the laws, rules and guidance that were available to you at the time you submitted your application; provided, if your application has not yet been processed, you are also entitled to update such application if your underlying assumptions and analyses are affected by subsequent regulations and interpretations.

If you have questions about small business loans and the PPP's affiliation rules, we encourage you to reach out to your Much attorney.

  1. Under the Act, the Rules are waived for any business a) with 500 or fewer employees, that as of the date the PPP loan is disbursed, is assigned a North American Industry Classification System code beginning with 72, b) that is operating as a franchise with a franchise identifier assigned by the SBA, or c) that receives financial assistance from a company licensed under §301 of the Small Business Investment Act of 1958 (15 U.S.C. 681). Furthermore, under the Religious Exemption Guidance, the Rules do not apply to persons or entities that are affiliated based on a faith-based relationship.

  2. Under the guidance, the SBA has stated that the determination of whether a Business Concern is a "small business" can also be determined based on the applicable employee-based/revenue-based standards or the alternative size standard, each of which is provided under the SBA's regulations, provided the Rules are applied with respect to these standards, if applicable.

  3. Affiliation is not created if the options, convertible securities, or equivalent, are subject to certain conditions precedent that are a) incapable of fulfillment, b) speculative, conjectural or unenforceable under federal law, or c) the probability of exercise is extremely remote.

  4. Under the guidance, the SBA has stated that if a Presumed Owner irrevocably waives or relinquishes such rights, then such Presumed Owner would not trigger the Rules (assuming no other circumstances relating to the Presumed Owner would trigger the Rules).

  5. "Close relatives" is a defined under the SBA and means a spouse, parent, child or sibling, or the spouse of any such person.

Disclaimer: We are providing the current SBA Loan Application and links to related information as a convenience. The application and related requirements may change and we are not responsible for updating this information. By providing this information, we are not giving legal or tax advice. For advice on your specific situation, please contact your advisors.

© 2023 Much Shelist, P.C.National Law Review, Volume X, Number 100

About this Author

Peter A. Shepard Business & Finance Attorney Much Shelist

Peter focuses his practice on mergers and acquisitions and outside general counsel services for private and public companies, entrepreneurs, and private equity firms. Peter regularly represents private equity firms and highly acquisitive companies seeking to expand their businesses through acquisitions. In this role, he provides strategic advice and guides his clients through business combinations, capital raises, and exit opportunities. Peter also advises on corporate restructuring, joint ventures, and commercial finance transactions.

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