The Implications and Limitations of the CARES Act on Small Businesses and Startups

The Small Business Administration (SBA) is the US governmental agency which has been appointed to oversee part of the $2 trillion stimulus package drafted in response to the SARS-Cov-2 (Coronavirus) pandemic, COVID-19, and the economic crisis it has brought to the country. At the time of writing, there have been more than 787,000 confirmed COVID-19 cases across the globe, with at least 37,000 people succumbing to the virus. The United States currently has the greatest number of active cases of COVID-19 when compared with any other country (over 155k as of March 31, 2020). The measures that are being taken or encouraged by the relevant authorities to fight this crisis have resulted in significantly slowed or halted economic activities in most sectors. As such, the US government has quickly drafted a bill, the Coronavirus Aid, Relief, and Economic Security (CARES) Act, in order to address the financial implications of the current economic

Small business interruption loans in the CARES Act

The unprecedented bipartisan economic relief plan aims to aid economic stability by putting financial resources into the hands of the American people both directly and indirectly. The bill is organized into Divisions A-F and several sections of these divisions are aimed at aiding businesses to cope and recover from the economic impact of the pandemic. The first division, however, specifically addresses small businesses and allocates $349 billion in funding dedicated to this section. Small businesses employing no more than 500 individuals are eligible for loans to use for payroll (including paid sick, medical, and family leave), mortgage or rent, utilities, or other debt repayment obligations. The maximum loanable amount for any business is up to $10 million. An important section of this bill dictates guidance about loan forgiveness. Specifically, any portion of the loan used for maintaining payroll continuity between March 1st and June 30th, 2020, is eligible for debt forgiveness. This is an excellent provision in order to aid in protecting American employees of small businesses, although there are certain limitations of the loan forgiveness program, such as the reduction of the eligible amount in proportion to any reduction in the number of employees of a business. However, regardless of whether or not a loan amount is forgivable, certain venture backed companies may not even be eligible at all under what are known as “affiliation rules” under the SBA guidelines.

Defining the size of a business in accordance with SBA guidelines

The CARES Act uses SBA size standards to define what is considered a “small business concern.” For the purposes of the small business loans provisioned by the CARES Act, a business may have no more than 500 employees. Perhaps the assumption here is that larger businesses are financially robust enough to withstand the brunt of the economic turmoil and protect their employees. Regardless, there are limitations to funding and whether this assumption will hold true as the COVID-19 crisis develops is yet to be determined. Small businesses employing under 500 people across the United States comprise as much as 99.7% of the 5.6 million employer firms and employ approximately 58.9 million people, 46.8% of private sector payrolls in 2016. Although this is just slightly less than half, small businesses were responsible for the majority (61%) of jobs created in the US between 1993 and 2016. As such, it makes sense that the CARES Act prioritizes the protection and continuity of small businesses. However, there is a significant number of businesses which technically employ under 500 persons but are still unable to qualify for the small business loans due to affiliation rules.

Some startups may not qualify for CARES Act loans

The SBA stipulates that the annual receipts and the number of employees for both domestic and foreign affiliates should be accounted for when determining the size category of a business. Affiliation, as defined by SBA regulations, is determined by the ability to control a business, even when such control is not exercised. Their comprehensive guide highlights that affiliation exists when another business or third party has a controlling share in a business, has control of less than half of the voting stock but has a significantly larger portion than other shareholders, and in other scenarios which would apply to private equity firm or venture capital-backed (VC-backed) startups. In such a case, a business may be recognized as larger than a small business even if it only employs 30 individuals due to the size of its affiliates. A private equity or VC firm backing multiple unrelated small businesses which collectively employ over 500 employees would mean that none of the businesses in question would qualify for relief loans under the CARES Act and would most likely face difficult financial and operational decisions due to the impact of COVID-19.

Origins of the affiliation principles

The guidelines regarding affiliation were not originally developed to disadvantage VC-backed businesses. They were put in place to prevent subsidiaries of large corporations from taking advantage of programs which were meant to aid small businesses with limited access to funding and other resources. The rise of private equity and VC firms came about when certain start-ups came up with credible concepts but failed to get adequate funding for their ventures.

Considering that sources of funds for small businesses include personal funds (77%), bank loans (34%), and borrowing from friends and family (16%). Larger business ventures, particularly in technology, usually require significantly large capital outlays that cannot be shouldered by personal funds and familial sources and may be considered too risky for banks and other financial institutions. Although VC firms are relatively minimal in their contribution to the total startup funding pool (3%), their impact is profound. The average small business requires about $10,000 to open their doors and launch a business. On the other hand, the 0.05% of startups which manage to raise venture capital have an average seed round of $2.2 million. Although a significant number of these business ventures could fail, VC-backed companies represent some of the most innovative concepts and ideas with the potential to make a profound global impact.

VC firms and their backers are likely to be impacted by this global crisis, like everyone else in the American economy. They are less likely to be well-positioned to weather the storm than large corporations. As such, the CARES Act failing to distinguish between corporate and VC-backed startups is likely to have unintended consequences for vulnerable companies which are incubating potentially big ideas. Considering that running out of cash is the second leading cause of small business failure, a lack of adjustments to this bill to address the VC-backed startup gap is likely to result in a significant loss of employment and opportunities.

UPDATE:

The folks over at Lowenstein Sandler have provided a diverging opinion on some of the matters originally brought forth by the National Venture Capital Association, which concludes that most startups should actually qualify under their interpretation.