Despite a record stock market rebound, Middle America continues to struggle as the Covid-19 global pandemic persists.
While congressional discussions regarding additional stimulus measures languish along party lines, small and middle-market companies have witnessed the growing economic divide between their own businesses and the mega-cap companies such as Apple and Amazon that appear wholly unaffected by these turbulent times.
The pain, unfortunately, does not stop there, as businesses now are recognizing yet another issue which is holding them back. The Paycheck Protection Program (PPP), instituted earlier this year as a part of the CARES Act was intended to support small businesses suffering because of mandated government shutdowns initiated to slow the pandemic’s spread. Unfortunately, business owners and their advisors now are realizing that the uncertainty surrounding one aspect of the program—forgiveness of the balance due—is threatening mergers and acquisitions (M&A).
As a reminder, the PPP was enacted to provide loans to businesses with less than 500 total employees—with certain exceptions. Those loans were calculated by multiplying a business’s trailing payroll average by 2.5 times. Businesses were permitted to use the proceeds of those loans to cover certain eligible costs, such as 60% of payroll costs and other expenses such as utilities and rent. Perhaps the most important aspect of the program: if a business adhered to the parameters set out by the Treasury and Small Business Administration (SBA), the business eventually could apply to have the loan entirely forgiven.
This last point was undoubtedly the most appealing aspect of the PPP. As with all good things, many business owners and their advisors have come to realize that the promise of free money comes with unanticipated strings attached. Businesses
that were already engaged in the sale process pre-pandemic or have since put themselves up for sale are trapped by forgiveness uncertainty.
There are a number of unique issues facing the mergers and acquisition space for PPP loan recipients.
As discussed, eligibility for the program was predicated on a rigid calculation of the number of employees of a business. As long as that employee count did not exceed the applicable threshold, a potential borrower was considered eligible. An issue arises; however, when a business is still utilizing PPP loan proceeds prior to the Dec. 31, 2020, cut off. If that same business is exploring a sale prior to the deadline, depending on the status of the buyer and nature of the buyer’s business, a sale prior to the exhaustion of PPP loan funds could result in a seller becoming ineligible for forgiveness. For example, a business exploring a sale to a private equity buyer may become ineligible to apply for forgiveness upon consummation of the sale, since private equity firms received the unfavorable designation from the SBA as being “primarily engaged in investment or speculation, and such businesses are therefore ineligible to receive a PPP loan.”
Moreover, the shifting political landscape since the creation of the PPP in conjunction with some level of dissipating uncertainty given the broader market recovery, has led to some speculation whether companies already engaged in the sale process could make the required certification that “the uncertainty of current economic conditions makes necessary the loan request to support the ongoing operations of the eligible recipient.”
Commentators have focused on the Present Effect Rule which relates to an existing acquisition agreement being given present effect depending on how far along parties are in the deal-making process. In part, the rule considers “stock options, convertible securities, and agreements to merge (including agreements in principle) to have a present effect on the power to control a concern.”
Thus, a company already engaged in the sale process prior to the creation of the PPP potentially must consider the attributes of the buyer, such as the nature of the business and the number of employees in order to determine their own eligibility. Unsurprisingly, the facts and unique circumstances of each situation must be evaluated, as the applicability of the present effect rule is highly dependent upon the level of “definiteness” of existing deal documentation. In certain circumstances, a signed letter of intent—even if non-binding—could be considered to have present effect if such agreements or understandings contain definite terms and remain subject only to some level of diligence.
Finally, M&A advisors find themselves disturbed by the potential for subsequent Treasury and SBA guidance to further affect a contemplated asset purchase. At first glance, the present effect rule and other issues already discussed above seemed uniquely limited to an entity acquisition. This belief, however, has become strained as potential buyers and sellers of assets have examined the notes issued in conjunction with a PPP loan. In particular, the form note provided by the SBA to private lenders contains a default provision which can be triggered if a borrower “[r]eorganizes, merges, consolidates, or otherwise changes ownership of business structure without Lender’s prior written consent.” Despite the foregoing not specifically singling out an asset sale, lenders and certain commentators have signaled apprehension at the potential for a sale of substantially all of a business’s assets to implicitly fall within the default-triggering events.
Moreover, due to the rushed, haphazard, and sometimes contradictory guidance offered by the Treasury and SBA throughout the PPP process, there is no guarantee that the landscape will not be subject to further change. As demonstrated with the swift public outrage and subsequent response to reports that large publicly traded companies received PPP loans, regulators have embraced the unorthodox position of instituting regulations and rules after-the-fact that threaten the ability of business owners and their advisors to operate in a predictable regulatory environment. This is particularly concerning considering that tax law changes and regulations historically have been enacted on a prospective basis, since holding people accountable for rules that did not exist at the time a decision is made has a detrimental effect on business decisions.
The Solution—Delay or Escrow
When it comes to the world of M&A, nothing is worse than uncertainty. While the PPP has offered a lifeline to small businesses struggling across the country, the patchwork and piecemeal rule-making process has paralyzed the deal-making community. As of Aug. 10, the SBA finally began accepting applications for forgiveness from PPP borrowers; however, early guidance suggests that a final determination for forgiveness could take as long as 150 days. While some buyers and sellers may be willing to wait for such a determination before closing the deal, a wait time of nearly five months will assuredly have a chilling effect on M&A.
Buyers of both assets and entities have taken the logical position that PPP loans must be discharged at or before closing as questions of a potential future imposition of successor liability is untenable from a risk management perspective. Sellers, on the other hand, are trying their best to secure waivers from lenders for default provisions contained in their note as they attempt to have their cake and eat it too. While one cannot blame a seller for wanting free money and the full amount of a contemplated purchase price, these steps being taken by sellers appear to be particularly dubious given the existence of the Present Effect Rule. Ultimately, this current impasse among parties may only be resolved through the use of escrows in the amount of outstanding PPP loans.
If there is a lesson to be gleaned from this widespread confusion, it is that inconsistent and contradictory rulemaking and guidance can paralyze the intended beneficiaries.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Christopher Hanewald is a member of Wyatt, Tarrant & Combs LLP’s corporate and securities team in Memphis, Tenn.