Stuart McCallum, ASA, and George Wilmoth, CPA/PFS, CGMA, MST
More than a month after companies across the U.S. applied for the Paycheck Protection Program under the CARES Act, the Treasury issued guidance that detailed a few new requirements. On April 23, 2020, the Treasury updated its FAQs to state business owners must certify that “their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations…” necessitate their PPP loan application. Then on April 28, Treasury Secretary Steve Mnuchin fired a shot heard around the country when he said the SBA will be doing full reviews of all loans exceeding $2 million before approving forgiveness. In the wake of reading such additional requirements, after many businesses had already spent millions in PPP funds, panic was the natural reaction. While the language of these new requirements initially appears strong, there are options available to business owners to help mitigate these challenges.
Recent guidance from the Treasury indicates that borrowers (and their affiliates) with total PPP loan amount of less than $2 million will be assumed to be in compliance with the certification of financial need. For the companies with loans of $2 million or greater, the financial need component of the PPP is vague, at best. The original law was “that the uncertainty of current economic conditions makes necessary the loan request to support the ongoing operations of the eligible recipient.” Insofar as the technical requirement has been expanded to include theoretical access to capital, the practical requirement hasn’t changed that much. We will address both the economic and financial requirements here.
The certification was an assessment of the economy and your business at the exact time of your application. Keeping that particular date in mind, the documentation of your business’s needs narrows down to a scope that is more easily manageable. From an economic perspective, we recommend that you stick to the facts, with those including, but not limited to:
- Stock markets indicated a steep drop in investor sentiment. Depending on where your business fits the economy and when you submitted your application, the various equity markets had declines from -20% (NASDAQ) to -35% (Russell 2000).
- Moody’s Baa bonds experienced a spike in yield in late March and early April, indicating a squeeze from investor uncertainty regarding corporate strength and economic outlook. Corporate yields increased from 3.29% on March 6 to 5.15% on March 20. This was a 25% greater swing than during the darkest days of the financial crisis and that swing took 22 months to manifest. This recent spike in corporate yields happened in 14 days.
- Oil remains a topic of discussion through today as it generally serves as a forward indicator of economic growth. In April, the price of oil futures dropped to negative for the first time ever. Depending on your application date, you’re probably looking at a decline in the June Crude Oil contracts of around 45%.
- Treasury yields, a forward indicator of economic growth, declined nearly 72% in early April from their 52-week highs.
These are just a sampling of a nearly endless supply of economic indicators that you could draw from to document the economic uncertainty at the time of your application. Taking these data points together, it would appear at the time of most PPP applications under the initial batch that equity investor interest was negligible, corporate debt yields had spiked due to lack of investor confidence, and that oil and treasury yields were indicating troubling economic times ahead. Regardless of industry, it would seem there was definite economic uncertainty and a tightening of capital availability. For the purposes of your PPP loan, we recommend running a similar analysis with whatever economic indicators are most relevant to your company.
The above line of thinking addresses the economic uncertainty that is the first hurdle to certifying your need for the loan. Subsequent guidance states that you or your business also had, at the time of your application, a financial need for the loan. Before talking specific ideas related to this topic, we will restate the guidance from the Treasury: “All borrowers should review carefully the required certification that ‘current economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.’ Borrowers must make this certification in good faith, taking into account their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business.” The updated guidance really appears to be clarifying the original “need” requirement and not necessarily redefining or expanding the requirement.
With respect to the financial need component of the certification, there are two key items that you will need to assess and document – access to liquidity and whether the capital is detrimental to the business. In the past several weeks there have been numerous news stories regarding large and well-known companies securing funds under the PPP. The resulting backlash came in the form of the liquidity consideration of the requirement. For nearly all privately-held companies, however, access to outside capital was limited to nonexistent for several reasons. Firstly, the underwriting process for a bank loan can take weeks, sometimes months. Bond offerings can take even longer. For a flash recession like the coronavirus, companies needed immediate capital. Secondly, many financial institutions took a “wait and see” approach during the stock market free fall. We had a client left at the altar by a large national bank a few days before the refinancing of their building due to uncertain economic times. Lastly, most financial institutions were overrun with PPP loan requests, tying up otherwise available underwriters and commercial lending relationship managers.
Regardless of the availability of outside capital, the possibility of capital is yet another headwind worth considering in your documentation. In many cases, companies may not have been eligible for additional outside debt capital due to existing loan covenants, typical industry leverage ratios and an evaporation of company EBITDA. Traditional loans are largely issued as a ratio of EBITDA, or earnings before interest, tax, depreciation and amortization. Ceteris paribus, a company with $5 million of EBITDA should theoretically be able to borrow half as much as a similar company with $10 million of EBITDA. Along the same lines, a company that was previously making $5 million of EBITDA in 2019 and generated negative EBITDA during the shelter-in-place order likely has an impaired ability to raise outside debt from traditional lenders. For documentation purposes, we recommend a robust sensitivity testing that computes profitability and liquidity ratios over a range of debt levels that could potentially be necessary to finance operations if the PPP program didn’t exist. We also recommend documenting the number of jobs that would be terminated under each scenario, assuming that in the absence of the PPP loan payroll would be reduced.
Inside capital availability may pose a challenge for many borrowers who certified a need for the PPP loan. It really depends on the amount of cash sitting on the balance sheet as well as the potential uses of that cash. Again, documentation is paramount. For example, $2 million of cash on the balance sheet may appear to be available for continuing operations; however, there are a myriad of uses that money may be on reserve to cover. For example, if there is a chance their working capital lender may curtail a portion or all of their inventory financing. There may be deferred maintenance items such as roof repairs or near-term construction projects. There may be doubts of customer payments and defaults so the cash is necessary to float receivables or other working capital items. Some of the cash may even be earmarked for expenses that have yet to be accrued, such as third-party executive profit sharing for the prior year’s performance that you’re contractually obligated to payout.
Many questions still linger regarding the actual mechanics of the PPP loan program. The rhetoric from the administration has rightfully caused panic among businesses that have already used some or all of the loaned funds. While the suggestions in this article aren’t guarantees of forgiveness or success against a Treasury or SBA audit of your PPP loan, these steps are directionally the course that borrowers should take today in order to put them in the best position to withstand an inspection by PPP auditors.