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On April 10, 2023, SBA published the Final Rule on Affiliation and Lending Criteria for the SBA Business Loan Programs (88 FR 21074, effective May 11, 2023) (click here to access the Final Rule). This rule removed the principle of control, both affirmative and negative control, as establishing affiliation between entities. In light of the Final Rule, it is commonly assumed that affiliation is solely determined by various degrees of existing common ownership amongst multiple entities as described in SOP 50 10 8. It is important that SBA lenders keep in mind that affiliation may also be based on stock options, convertible securities and agreements to merge. SBA considers stock options, convertible securities, and agreements to merge (including agreements in principle) to have a present effect on the ownership of the entity. Further, SBA treats such options, convertible securities, and agreements as though the rights granted have been exercised.
To that end, it is helpful for lenders to have a general understanding of these ownership concepts:
Stock Options
A stock option is a contract giving the holder the right to buy a stated number of shares at a fixed exercise or strike price during a specified period.
From a transaction standpoint, the key questions are usually whether options are vested, what happens on a sale of the company, and whether the plan or award agreement permits acceleration, cash-out, assumption, or substitution by the acquirer.
Practice pointers on stock options:
- Confirm the number of authorized and reserved shares before grants are made.
- Review the plan document, board approvals, grant notices, and award agreements together rather than in isolation.
- Identify change-of-control provisions early, including single-trigger and double-trigger acceleration concepts.
- Check transfer restrictions, exercise windows, and any repurchase rights tied to termination of service.
Convertible Securities
Convertible securities are usually bonds, notes, or preferred stock that can be converted into common equity under stated terms. They are often described as hybrid instruments because they combine features of debt or preferred equity with an embedded right to participate in the company’s equity potential.
Common convertible securities terms:
- Conversion price: the price at which the instrument converts into common stock.
- Conversion ratio: the number of common shares received on conversion.
- Conversion period: the period during which conversion may be exercised.
- Call feature: a right of the company to redeem the convertible securities earlier in certain circumstances.
- Put feature: the right of the convertible securities holder to require earlier repayment in certain circumstances.
Agreements to Merge
A merger transaction usually moves from preliminary understandings into a definitive agreement that sets out the binding legal commitments of the parties. Before the definitive merger agreement is signed, parties often negotiate a letter of intent, term sheet, memorandum of understanding, or other agreement in principle that captures the main business terms.
An agreement in principle typically shows that the parties are aligned on major points such as structure, consideration, exclusivity, diligence process, approvals, and timing, even though the full legal documentation is not yet complete. In many transactions, most of the economic provisions remain non-binding at that stage, while selected provisions such as confidentiality, exclusivity, access, governing law, expenses, or no-shop obligations may be expressly binding.
Issues to understand in agreements in principle:
- Understand clearly which provisions are binding and which are not.
- Define transaction structure early, such as merger, stock purchase, or asset purchase.
- Understand due diligence scope, timing, and information access.
- Confirm required approvals, including board, shareholder, lender, and regulatory approvals where applicable.
Definitive merger agreement
The definitive merger or purchase agreement is the final binding contract that records the complete terms and conditions of the transaction. It typically covers purchase price and payment mechanics, representations and warranties, covenants, closing conditions, termination rights, and other provisions that govern signing, pre-closing conduct, and closing risk allocation.
Stock options, convertible securities and agreements to merge differ in form, but each one requires attention to conversion mechanics, dilution, vesting, approvals, and remedies if the contemplated transaction changes course. For SBA lenders who need to determine whether affiliation may be deemed to exist, it is helpful to ask the following questions:
- What right is being created;
- Who is the holder/benefitted party of the right being created;
- When does it become exercisable or binding; and
- What is the resulting ownership of the company once the right has been exercised and becomes legally binding.
It is also helpful for lenders to remember that SOP 50 10 8 provides the following clarifications:
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Agreements to open or continue negotiations towards the possibility of a merger or a sale of stock at some later date are not considered “agreements in principle” and are thus not given present effect.
- Options, convertible securities, and agreements that are subject to conditions precedent which are incapable of fulfillment, speculative, conjectural, or unenforceable under state or Federal law, or where the probability of the transaction (or exercise of the rights) occurring is shown to be extremely remote, are not given present effect.
- SBA will not give present effect to individuals', concerns', or other entities' ability to divest all or part of their ownership interest to avoid a finding of affiliation.
If your lending institution has questions about SBA affiliation determinations, or any other SBA lending matters, please contact us at SBAQuestions@JellumLaw.com.
This article is provided for general information and educational purposes only. It does not solicit, establish, or continue an attorney-client relationship. The contents should not be construed as legal advice or opinion. If the organization would like formal legal advice, our professional liability insurer (as well as the applicable attorney ethical rules) requires that we establish a formal attorney-client relationship. If you are interested in learning more about working with Jellum Law, please contact us at SBAQuestions@JellumLaw.com.
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