The SBA signaled startups could apply for loans, but some urge caution

  • The federal government seems once again to be encouraging startups to participate in a multi-billion loan program aimed at helping small businesses during the coronavirus crisis.
  • The Small Business Administration, which runs the program, issued new guidance on Wednesday that seemingly addressed a big concern startups founders and their backers had about it — advising companies that the agency would consider any loan applications for amounts less than $2 million to have been made in good faith, with regards for their necessity.
  • Many startups were dissuaded from participating in the program by guidance the agency issued late last month that indicated it would look critically at whether applicants, particularly those backed by venture capital and other private equity firms, really needed it.
  • While many startups may now consider applying, Ed Zimmerman, a lawyer who advises VC firms and their portfolio companies, is warning clients to be cautious, because companies who get loans could still be audited or prosecuted.
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After a series of mixed messages that confused and frightened venture-funded startups, the federal government is flashing the green light to let them know it’s safe to borrow money from the small business loan program. 

But the effort may not be enough to overcome misgivings among the startups who are grappling with the coronavirus pandemic’s economic shocks that the nearly $700 billion loan program is supposed to mitigate.

On Wednesday the Small Business Association and the Treasury Department updated the guidelines around the Paycheck Protection Program. In an update to a list of  frequently asked questions, the SBA said it would now deem all loan applications for less than $2 million to have been made in good faith. At least at first glance, that move seems to have addressed a big reservation many venture-backed startups have had about the program — that the government could and would determine after the fact that they didn’t actually need the money and might even prosecute them for taking it.

Many startups who may have been on the fence about the program or may have already even returned money they received under it for fear that they didn’t qualify may see the new guidance as the government’s stamp of approval for them to participate in the program, as long as they borrow something less than $2 million, said Ed Zimmerman, chair of the tech group at the law firm Lowenstein Sandler, who has been closely following developments in the PPP.

“I think lot of lawyers are telling their clients, ‘It’s now free money. Go for it,'” he said.

The SBA’s guidance has gone back and forth

Congress created the PPP as part of the $2 trillion stimulus package it passed in March. As part of that law, government set aside $349 billion for loans to small businesses to use on payroll, rent or mortgage payments, and utilities. After the initial funding ran out, Congress added another $320 billion to the program. The loans were supposed to help keep the businesses afloat and their workers employed. The government promised to forgive loans to companies that used them for the named purposes.

Congress didn’t specify whether or not venture-backed startups would qualify for the program, and the guidance issued by the SBA and Treasury Department since late March has been confusing to many. Initially, it seemed like startups wouldn’t be able to participate because they’d be too big to count as small businesses, due to existing SBA rules that would have forced them to count as their employees not just their own workforces but those of other companies owned by their venture backers. The SBA cleared up that issue, which seemed to allow startups to participate.

But then, in the wake of news that Shake Shack and other big companies got loans under the program, the SBA and Treasury Department issued new guidance in late April that again seemed to exclude startups from participating. The SBA warned companies they must certify that they actually needed the loan funds. When assessing that need, companies — particularly those backed by private-equity firms — needed to consider whether they had access to alternative sources of funding, such as from their investors. Venture capital are generally considered to be a kind of private equity.

Interest in the PPP loans among startup founders and venture capitalists has gone back and forth as the government’s guidance on it has changed, Zimmerman said.

“It’s a pendulum, and it’s swinging wildly,” he said.

As part of the guidelines it issued late last month, the SBA said it would audit all loans of more than $2 million and some of those for smaller amounts. Treasury Secretary Steve Mnuchin threatened to have companies that falsely certified that they needed the loans be criminally prosecuted.

Many startups pulled out of the program

In the wake of that guidance, many startups that otherwise would have taken out loans under PPP decided to either forgo the program or to return loans they received, venture capitalists told Business Insider. About half of Menlo Venture’s portfolio companies had planned to apply for PPP loans, said Matt Murphy, a partner with the firm. After the SBA issued its guidance about alternative sources of funding, less than 10% of its portfolio companies ended up both apply for and keeping the PPP money, he said.

Meanwhile, about one-quarter of the companies in Sapphire Ventures’ portfolio applied for and received loans under the program, Jai Das, the firm’s president said. But after the guidance came out, nearly all of them returned it. Only one or two kept the money, he said.

The new guidance “changed the game a little bit for a number of companies, and they decided not take it,” Murphy said.

Indeed, potentially as a result of the threats of audits and prosecution, interest in the program seems to have waned. Although the SBA quickly exhausted its first tranche of money under the PPP program, it still had more than $127 million left under the program as of Wednesday.

Instead of taking out the loans, many such startups laid off workers instead to reduce their cash burn or sought out other sources of capital, such as lines of credit, the venture capitalists told Business Insider.

Zimmerman is advising startups to remain cautious

The new guidelines seemed aimed to reduce fear among potential borrowers and encourage them to take out loans under the program. But for his part, Zimmerman is still urging his clients to be cautious. It’s unclear how much legal weight to give a statement made by the SBA in an FAQ document, he said.

Even if one assumes it’s equivalent to a regulation or a law, the document still leaves room for uncertainty, he said. In the FAQ, the SBA seemed to leave open the possibility that it might still audit loans of less than $2 million and could force companies to repay loans if it determined they didn’t need the money, he said.

With all the back-and-forth guidance, “the government has breached trust here,” he said. “How do you now rely on government statements at this point?”

What’s more, even if the SBA’s latest guidance can be taken at face value, it’s not binding on other governmental agencies, Zimmerman said. The Department of Justice, state attorneys general, and even the Office of the Inspector General of the Federal Deposit Insurance Corporation could still investigate companies that took out PPP loans of whatever size.

And it may be a red flag to such law enforcement officials and regulators if a company applied for a loan after the latest change after either pulling its application or repaying a loan following the prior guidance, he warned. Such a sequence of events might suggest to law enforcement officials that a company’s leadership didn’t really believe the company qualified for the loans.

The big question is whether “people are going to draw that negative inference and say the only reason you applied is because we told you you wouldn’t get caught,” Zimmerman said.

Regardless, the latest change is likely going to lead to more stress among startup founders and their VC backers, he said.

“This definitely triggers another round of hand-wringing, another round of relationship-fraying conversations around board rooms,” Zimmerman said.

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