INSIGHT: Supporting America’s Startups—Too Medium to Survive?

As the government pours money into the economy through numerous stimulus programs under the CARES Act, policymakers have largely ignored an important sector of the economy that will be key to the nation’s recovery: investment-backed tech startups.

Although startups employ millions of people in the U.S. and drive American innovation, the key financial support programs aimed at supporting U.S. businesses, small and large, have so far imposed eligibility rules that startups often fail to meet.

Too Big to Qualify

Many startups have failed to qualify for funding under the CARES Act’s marquee program for small business, the Paycheck Protection Program, or PPP. That program was designed to pump forgivable loans into America’s small businesses—generally those with fewer than 500 employees—to use for payroll and to otherwise keep the lights on. Many startups were thwarted from eligibility because—despite having a small number of employees—they were considered too big to qualify. This was because the rules for counting employees, known as the affiliation rules, count not only the employees of the company itself but also the employees of other companies with the same investors.

In general, these rules are meant to prevent large companies from formally spinning off smaller entities to get government loans, but venture capital and private equity investors tend to retain the sort of control over their portfolio companies that can render the whole group a single company under the rules.

Affiliation rules thereby exclude each portfolio company from relief, unless the investor cedes their control rights. This means small companies get barred from obtaining government aid at a critical time merely because of the structure of their financing. In another context, by contrast—the restaurant industry—Congress waived affiliation rules to make larger restaurant chains with fewer than 500 employees per location eligible for loans under the PPP.

The Housed on April 23 passed and sent to President Donald Trump a bill to replenish the PPP with $320 billion after the initial $350 billion ran out in just 13 days. Venture capital industry groups have raised with the government their concern that investment-backed portfolio companies should not be left out based on the nature of their backing.

However, the new bill refunding the program—and another program providing “Emergency Injury Disaster Loans,” which are generally subject to the same affiliation rules—does not address these issues.

Left Out in the Cold

Even as these startups have been deemed too big for small business funding, they will also likely be ineligible for the Federal Reserve’s program for larger businesses, as it is currently construed. On April 9, the Federal Reserve answered Congress’s directive in the CARES Act by announcing the “Main Street” program to provide up to $600 billion in loans for businesses with up to 10,000 employees.

Yet, under the term sheet put out earlier in April, the maximum amount of a loan is tied to a business’s profits, meaning businesses without profits will effectively be ineligible for loans—a bar that will likely apply to many tech startups. In comments to the proposed term sheet, some have proposed alternative eligibility criteria, like using a business’s enterprise valuation. But with the program about to launch, it is unclear whether the Federal Reserve will heed those proposals.

Leaving startups out will not be without its downsides. America’s startups will be key to fueling job creation and recovery after the crisis. One report from the Information Technology & Innovation Foundation found that technology-based startups accounted for nearly 3% of U.S. firms and 1.5 million workers in 2016. The Kauffman Foundation found that startups created an average of 5.2 jobs per 1,000 people in 2018.

Along with the number of jobs these businesses create, startups drive American innovation and are the businesses of tomorrow. Technology startups invest in R&D more than established firms, which studies have found key to competing in international markets. And of course, many of the U.S.'s most valuable companies were once investment-backed tech startups.

A Needed Lifeline

By locking startups out of both major programs designed to allow companies to maintain payroll, the government is increasing the chances these startups will lay off employees or fail before their time. Of course, some might argue that companies without profits should not get government-backed relief. To be sure, even before the pandemic hit, many had begun to question the value of earnings-less, early-stage companies, in the wake of the failed WeWork IPO.

But, in a period when all companies are facing an existential threat from a once-in-a-century global event, we should not throw the baby out with the bath water. A key goal of the CARES Act is to help Americans keep their jobs—and startup jobs are as valuable as any other. Businesses across the economy are getting a lifeline, and these companies should be given a chance to survive or fail on their merits, and not because of the crisis.

Of course, there is a legitimate ongoing debate about whether and when venture-backed firms should decide to take program money. But it is better that the process should play out on a case-by-case basis, with firms making their own individual decisions, rather than precluding such choices through a more categorical exclusion. Some of these companies have a cushion of cash on hand from investors, but for some companies anticipated shortfalls in expected revenues will inevitably lead to the same kinds of adverse payroll decisions other businesses are facing. Allowing those companies a bridge through this period will allow the selection process to play out while helping ensure more Americans remain employed.

In all, the global pandemic is showing the importance of technology and innovation to America’s crisis response. The coming months and years are poised to show that companies built on those principles are key to the country’s recovery. Policymakers should make sure they are still around to play that role by offering the funding that will allow them to survive.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Michael W. Ross, a partner in Jenner & Block’s Complex Commercial Litigation and Securities Litigation Practices, represents corporate clients in complex disputes, investigations and regulatory challenges. Mr. Ross spearheaded the formation of the firm’s Fintech group and has been recognized by New York Law Journal for his work in the Fintech space.

Isabel Farhi is a law clerk in the firm’s Litigation Department.