By Tom Zanki

Law360 (April 3, 2020, 6:33 PM EDT ) Certain venture-backed startups may be ineligible for relief loans aimed at small businesses struggling to pay employees during the coronavirus pandemic, prompting fears that many distressed startups will be denied aid amid a brutal cash crunch.

Lawyers say the issue is how the Small Business Administration, which is administering rescue loans authorized by the federal government, calculates employees based on its affiliation rules. Businesses must employ fewer than 500 employees in order to be eligible for loans under a $349 billion provision in the Coronavirus Aid, Relief and Economic Security Act, or CARES, Act.

Because many startups are backed by venture capital or private equity firms that employ more than 500 employees across all their portfolio companies, lawyers say some companies could miss out on aid even if they individually employ less than 500. The SBA generally considers a company's affiliates and totals head count across the board when calculating employee levels. Such rules are intended to prevent large companies from accessing benefits aimed at small ones.

With funding applications allowed to begin on Friday, lawyers say they are seeking more clarity from the SBA and the Treasury Department to explain how affiliation rules will be applied.

Fenwick & West LLP partner Mark Leahy said he has venture-backed clients who fall in a gray area in terms of whether they are eligible for loans under SBA rules. He compared the situation to being stuck in "a holding pattern with the gun about to be fired."

"Companies are very anxious and eager about this right now and I am sure I am one of many corporate attorneys who are getting calls from nearly all clients about who might be eligible," Leahy said.

Investor groups such as the National Capital Venture Association are lobbying the Treasury Department to clarify that businesses backed by equity investors will not be excluded from CARES Act loans. Politicians are getting involved, too. House Minority Leader Kevin McCarthy, R-Calif., on Thursday told news site Axios that he expects the Treasury Department to release guidance soon clarifying that venture-backed companies will be covered under the legislation.

Messages seeking comment from the Treasury Department and SBA were not returned on Friday. Karen Mills, a former SBA head and now a member of a U.S. Securities and Exchange Commission advisory committee focused on small business capital formation, said at a meeting Thursday that many banks are still navigating complex rules around loan requirements.

On March 27, President Donald Trump signed the CARES Act, which provides more than $2 trillion in relief for various businesses and individuals.  

The loans, authorized under the CARES Act's Payroll Protection Program, allow small businesses to borrow up to $10 million at 1% interest and maturity of two years. Loans can be fully forgiven if proceeds are spent on payroll costs, and most mortgage interest, rent, and utility costs over eight weeks after the loan is made, according to Treasury Department guidance. Loan forgiveness can be reduced if a company reduces staff or decreases salary and wages.

Lawyers are watching how the SBA will apply its affiliation rules, which are determined case by case based on a concept of control. For instance, if a particular shareholder owns more than 50% of a company, that would establish control. Lawyers note that many venture-backed startups are more likely to be owned by several firms and founders with minority stakes.

Complicating matters is that shareholders of startups, even if they don't own a majority stake, may hold what are called "protective provisions" that grant them special rights, including the ability to block certain transactions. Lawyers say it is still unclear how rules would apply under varying scenarios, but time is of the essence considering urgent funding needs of companies.

"The need from the startup community for this is very real," Paul Hastings LLP partner Chris Austin said. "We are spending a lot of our time right now helping people figure out how to furlough and terminate employees, and how to pay their rent."

Austin added that many early-stage companies are not yet profitable, especially in the technology and life sciences industries, making them dependent on new financing. However, the venture financing market is drying up amid economic uncertainty caused by the pandemic.

"In many cases, these loans could mean the difference between getting through this and having to find someone to wind up the company or sell the company," Austin said.

For the time being, lawyers say they are advising their clients to prepare loan applications if they believe they have a good case but also to be ready to proceed if they are not eligible. Outside of the loans available under the PPP section of the CARES Act, the legislation provides benefits for small businesses in other areas including forgiveness or deferral of payroll taxes.

Baker Botts LLP partner Michael Torosian noted that large venture-backed firms can separately access loans under a CARES Act program that does not include the SBA's affiliation rules, albeit at less attractive terms. Such loans would apply to companies with 500 to 10,000 employees.

Given that venture groups and politicians are lobbying for relaxing the SBA's affiliation restrictions as it applies to PPP loans, lawyers are watching for updates from the government.

"There are a lot of jobs at stake here, and it is very meaningful for not only our community and the venture industry, but the technology industry and life sciences industry as a whole," Torosian said. "If we are talking about keeping jobs for startup and emerging companies, then this act in the PPP needs to include funding for those companies irrespective of whether they are backed by VC or PE."

--Editing by Jay Jackson Jr.

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