Payroll Protection Program Loans appear to be an obvious choice for cash-strapped startups. Yet PPP Loans come with hidden drawbacks, particularly when planning a sale of the company. Some are triggered at the time of drawing down the loan and others only at the time of forgiveness.
Benefit: Free Money
PPP Loans can be relatively easily forgiven. To qualify for forgiveness, the borrower must show: (i) an adverse impact from the pandemic, (ii) the absence of alternative sources of financing, and (iii) spending on certain approved expenses over a 24-week period. Qualifying expenses include payroll (up to $100,000 per employee), certain employee benefits, rent and utilities. Many startups who take PPP Loans are likely to qualify for forgiveness.
Drawback #1: No Tax Write-off for Expenses Paid with PPP Loan
Most startups and venture-backed companies are organized as C-Corporations. When a PPP Loan is forgiven, a C-Corporation can deduct no expenses paid by the PPP Loan proceeds. This reduces the after-tax benefit of a PPP Loan for C-Corporations. Here, the PPP Loan proceeds are effectively taxed at the federal corporate tax rate of 21% (in addition to the state corporate tax rate).
Drawback #2: Affiliation Rules
To qualify for a PPP Loan, the borrower cannot have over 500 employees. Considered on their own, startups typically will have no problem with this rule. However, the 500-employee limit applies to employees of all affiliates. If a shareholder owns 50% or more of a startup or exercises operational control, the employees of that shareholder and the shareholder’s affiliates must be included. Before applying for forgiveness, if they haven’t done so already, borrowers need to consider the impact of the affiliation rules.
Drawback #3: Friction in Acquisitions
PPP Loans cause issues when a startup is being sold, particularly when the buyer is a strategic acquirer. The acquirer may require that the borrower not apply for forgiveness, or forgiveness may not be possible after the acquisition. A startup may have to pay back the PPP Loan following an acquisition when it would otherwise have qualified for forgiveness.
Drawback #4: Acquirers of Startups Cannot Claim ERTC
The employee retention tax credit (ERTC) provides a payroll tax credit of up to $5,000 per employee for qualifying employers. Employers who receive a PPP Loan do not qualify for the ERTC. Most startups will have no problem giving up the ERTC for a PPP Loan. However, the ERTC does not have a 500-employee limit and some strategic acquirers want to claim the ERTC. These acquirers will want to avoid directly acquiring a startup with a PPP Loan.
Drawback #5: SBA Audit
Borrowers of PPP Loans over $2 million will face an automatic audit from the SBA, the agency in charge of administering PPP Loans. While few startups will borrow PPP Loans over the $2 million threshold, this is an important consideration for those borrowing more than $2 million.
Many startups will conclude that PPP Loans provide that most uncommon of benefits: free money. But there ain’t no such thing as a free lunch, even for PPP Loans. In particular, startups planning to be acquired by a strategic acquirer need to think twice. And startups with majority shareholders or with shareholders exercising operational control need to determine if the affiliate rules apply.