State of Play: Venture Backed Startups, the Paycheck Protection Program and the Affiliation Rule

April 8, 2020

By: Allan Grauberd

On March 27, 2020, the President signed into law (after being passed by the Senate on March 25, 2020 and subsequently passed by the House of Representatives on March 27, 2020) the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which establishes the Paycheck Protection Program (the “PPP”) providing forgivable loans for small business within the infrastructure of the Small Business Administration (the “SBA”). Under the PPP, up to $349 billion is allocated for loans that will be fully forgiven when used for payroll costs (capped at $100,000 annually per each employee), interest on mortgage obligations incurred before February 15, 2020, rent under lease agreements in force before February 15, 2020, and utilities for which service began before February 15, 2020, to businesses with less than 500 employees. Included within payroll costs are salary, employee benefits (including vacation, family, medical, or sick leave and health care benefits) and state and local taxes. If proceeds from the loan are used for any other expense, repayment will be due in two years at a 1% fixed interest rate. These loans are intended to provide for up to eight weeks of an entity’s, monthly payroll costs calculated from last year’s payroll plus an additional 25%, and are capped at $10 million1. The PPP will undoubtedly be helpful in keeping the lights on for many start-ups, but what does the PPP mean for venture backed start-ups?

The National Venture Capital Association and other groups have been lobbying for the SBA to adopt language that will allow venture backed start-ups to be eligible for the PPP by waiving the “affiliation rule” for such firms. Despite recent hopeful reports2, no such waiver has been made in the Interim Final Rule (as further discussed below).  The “affiliation rule” requires businesses that are under the common control of another business to be counted together when determining a business’s employee count, which could then cause all of a venture capital firm’s portfolio companies’ employees (and that of the firm itself) to aggregate over 500 employees, thus disqualifying all the companies in the affiliated group3.

In relation to the PPP, on April 3, 2020, the Treasury department issued its Interim Final Rule, where it stated: 

…[T]he detailed affiliation standards contained in section 121.1034 [of the 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 § 121.3014.

So, what does that mean for venture backed start-ups?6 13 C.F.R. § 121.301 provides that an affiliation may arise in circumstances where:

  1. any single equity holder owns more than 50% of the start-up’s voting equity.  Even where there exists no single majority equity holder, the SBA will consider a minority equity holder to be in control, if that individual has the ability to prevent quorum or otherwise block action by the start-up’s board of directors or other equity holders (emphasis added)7. Thus the typical group of protective covenants in a series preferred may trigger the affiliation status if a single holder controls the protective covenant, but there needs to be further analysis of the type of protective provisions in force, as well as possible remedial steps, as discussed below.
  2. for purposes of determining control, if there are any issued options, convertible securities or exercisable securities, the SBA will deem those securities as-converted or as-exercised unless those securities (or the conversion or exercise rights) depend on conditions that are incapable of fulfillment, speculative or unenforceable under the law8;
  3. a single president or CEO or other control person acts to control  two or more entities9;
  4. current or former officers, directors, owners of a 20% interest or more, managing members, or persons hired to manage day-to-day operations of one start-up organize a new start-up in the same or related industry or field of operation, and serve as the new start-up’s officers, directors, owners of a 20% interest or more, or managing members, and there are direct monetary benefits flowing from the new start-up to the original start-up10;
  5. a start-up derived more than 85% of its receipts over the previous three fiscal years from a contractual relationship with another business, unless: (A) The contract (or contracts) does not restrict the start-up in question from selling the same type of products or services to another purchaser; or (B) SBA agrees that the terms of the contract (or contracts) do not provide the purchaser with control or the power to control the seller11; or
  6. a totality of the circumstances may amount to an affiliation, “even though no single factor is sufficient to constitute affiliation12.”

One of the major “affiliation rule” provisions that poses an issue for venture backed start-ups are the “negative controls” or “protective provisions,” (discussed in (1) above) which means that an affiliation could be found when a minority shareholder, under a venture backed start-up’s charter, bylaws or shareholders agreement, has the ability to prevent quorum or block an action by the board of directors or other shareholders. Many series preferred have protective provisions that control both fundamental transactions (e.g., a sale of the company or amendments to the charter), as well as operational matters (e.g., incurrence of debt or hiring of executives)13.

There are a number of methods that may alleviate the effect of protective provisions from constituting affiliation, such as (i) irrevocable waivers of certain protective provisions14; (ii) use of a voting agreement or proxy to transfer control to another or several other persons or entities, thus eliminating the single controller of the protective provisions; or (iii) arguing that protective provisions for fundamental transactions are not control indicia, but rather focus on the protection of the investor’s fundamental economic rights—this would involve perhaps a less extreme version of (i) and (ii) so that only operational protective provisions need to be waived or modified.

There is a great deal of granularity that needs to go into the affiliation analysis but there are enough ways to manage the control factors so that most venture backed start-ups have a reasonable chance of establishing eligibility if the VCs backing it are prepared to assist in modifying or waiving some of the potential  affiliation factors.

There is still also a chance that the regulations or guidance will change in a manner beneficial to VC backed start-ups. We will be updating this content if that occurs.                

Should you have any questions or concerns, please contact any of the attorneys in the Corporate or Securities and Capital Market Groups. 


1. See Paycheck Protection Program (PPP) Information Sheet: Borrowers, U.S. Treasury Department.

2. See Dan Primack, Kevin McCarthy: startups will be eligible for coronavirus stimulus loans, Axios (April 2, 2020).

3. Note that the PPP has alternate eligibility standards that are not subject to the 500 employee limit but these also apply affiliation rules. See Questions 2 and 5, Paycheck Protection Program Loans Frequently Asked Questions (FAQs), U.S. Treasury Department updated, April 7, 2020.

4. The SBA utilizes the affiliation standards set forth in 13 CFR § 121.103 in other SBA programs.

5. See Business Loan Program Temporary Changes; Paycheck Protection Program Interim Final Rule, 13 CFR Part 120.

6. It should be noted that the “affiliation rule” does not apply to venture backed start-ups in the hospitality and restaurant industries See CARES Act, Section 1102, Paycheck Protection Program; and supra note 1.

7. See 13 C.F.R. § 121.301(f)(1).

8. See 13 C.F.R. § 121.301(f)(2).

9. See 13 C.F.R. § 121.301(f)(3).

10. See 13 C.F.R. § 121.301(f)(5).

11. See 13 C.F.R. § 121.301(f)(4).

12. See 13 C.F.R. § 121.301(f)(6). The regulations do not provide what circumstances will amount to affiliation, but state, “[the] SBA may find affiliation on a case-by-case basis where there is clear and convincing evidence based on the totality of the circumstances. However, where an SBA Lender has made a determination of no affiliation, SBA will not overturn that determination as long as it was reasonable when made given the information available to the SBA Lender at the time.”

13. The distinction between protective provisions with respect to fundamental transactions and operational actions, is not enumerated in 13 C.F.R. § 121.301(f), but rather is derived from interpretations of 13 CFR § 121.103 in SBA appeals. While §121.103 is not applicable to determination of affiliation of 13 CFR § 121.301(f), we believe the distinction between these two categories of protective provisions should still be made under §121.301(f). 

14. On April 7, 2020, the Treasury Department issued guidance regarding the PPP. Particularly, it provided an answer on the following question: if a minority shareholder irrevocably waives or relinquishes its rights, is the venture backed start-up still considered an affiliate? It answered:  

If a minority shareholder in a business irrevocably waives or relinquishes any existing rights specified in 13 C.F.R. 121.301(f)(1), the minority shareholder would no longer be an affiliate of the business (assuming no other relationship that triggers the affiliation rules). See supra note 3.