Raising Capital is Never Easy: Finder Pitfalls
If you haven’t run a financing process before, then you likely believe that you should line up all the help that you can get. You may even engage a “finder” to help you raise money.
While there are many resources and advisors available to help your company prepare for and close rounds of financing, it is difficult to find high quality help that can make meaningful introductions to potential investors and assist in making your financing goals a reality.
In fact, in our experience, startups that engage finders to help raise money often are optimistic at the beginning of the relationship, only to be left with unmet expectations, unsatisfactory results (i.e., little or no money is raised) and potential legal issues if it turns out the finder was actually an unregistered broker-dealer.
To make matters worse, startups often are surprised to learn that the finders that they engaged to bring on investors may be operating as unregistered “broker-dealers” in the eyes of federal and state securities regulators.
Whether a finder should be registered as a broker-dealer depends on, among other things, the nature of the assistance provided and the compensation paid for success. And yes, as discussed below, the consequences of engaging a finder who should be registered as a broker-dealer can be very serious, both for the finder and the company raising money.
Below is the bottom-line information that you need to know in order to evaluate a proposed finder relationship when trying to raise money for your startup:
1. Your “Finder” is Likely an Unregistered Broker-Dealer
As general background, we use the term “unregistered broker-dealer” to mean an agent who assists a buyer and/or seller of securities in the fundraising process in a manner that otherwise requires registration as a broker-dealer. On the other hand, a “finder” refers to an agent whose activities do not trigger broker-dealer registration. More often than not, the activities and services provided by finders cross into unregistered broker-dealer territory, so it is important to understand the boundaries to help keep your company out of hot water.
Broker-Dealer vs. Finder
In general, the legal framework used to differentiate between an unregistered broker-dealer and a finder is based on a handful of key factors set forth by the U.S. Securities and Exchange Commission (SEC). The SEC’s guidance on broker-dealer registration highlights the key issues that you generally will need to review when determining whether a finder actually is an unregistered broker-dealer (and therefore should be registered as such). Note that the SEC interprets the definition of “broker” very broadly, so it is important to understand the types of activities that trigger broker-dealer registration.
If you have engaged a finder who is conducting any of the following activities without an active broker-dealer registration, then your company could face legal and regulatory issues (as discussed below):
Activities That Require Broker-Dealer Registration:
- Engagement involves receipt of transaction-based compensation or “success fees.” For example, compensation or success fees are calculated based on a percentage of the amount of money raised.
- Involvement in negotiations with or provision of detailed advice or information to a buyer or seller of securities.
- Involvement in the negotiation of financing documents related to the purchase and sale of securities.
- Solicitation of investors.
- Pre-screening potential investors to determine their eligibility to purchase securities and to gauge investors’ interest.
- Discussions or recommendations concerning securities.
- Persuading or incentivizing an investor to purchase a security.
It is important to note that registering as a broker-dealer and maintaining ongoing regulatory compliance are administratively burdensome and expensive. If it were otherwise, then more individuals and firms would register as broker-dealers. If you have hired a licensed broker-dealer to assist you with your financing, then you should confirm the status of their broker-dealer license and review any disclosure events (i.e., disputes, disciplinary actions, etc.) through FINRA’s Broker Check system.
2. Most Finder Arrangements Don’t Work
In our experience, most finder engagements improperly involve transaction-based compensation (a significant red flag), and most finders already have been involved in various other financing transactions (another significant red flag). Anyone who has raised early-stage financing can appreciate why this approach is so common:
- It makes sense to align economic interests and pay for results. Show me the money and you will be compensated!
- Except in special situations, who wants to hire someone who doesn’t have a track record of success?
We understand the strong pull to set up a finder relationship based on money raised (or success), and we understand why companies may prefer experienced finders over first-time finders. The problem is that the finder then would be acting like a broker-dealer and therefore broker-dealer registration would be required. Further, while finders come in all shapes and sizes, we have encountered more than a few financial mercenaries who either are not aware of the regulatory requirements or are willing to take on some risk if they can make some cash.
3. So What? The Consequences of Using or Acting as an Unregistered Broker:
We often hear startup entrepreneurs say thinks like: “What’s the big deal? I’m not raising that much money,” “What’s the likelihood that the regulators will catch me?” or “we are a lean startup (or we are bootstrapping this company) and we can’t spend too much money on legal.”
We get it. However, acting as an unregistered broker-dealer is against the law, and the consequences of working with a finder who is acting as such could be a big blow to your company and its future. The following is a list of the most common legal issues companies face when they have hired an unregistered broker-dealer:
Claims for Securities Fraud:
- Rescission Claims (i.e., company may be forced to return the money to investors)
- Regulatory Actions
- Future Deal Complications:
- Securities Law Compliance Problems for Future Financings
- Disclosure Issues
- Legal Opinion Challenges
- Tainted Financial Statements
- SEC Review Upon IPO
For the unregistered broker-dealer, the most immediate risk is that this type of arrangement is unenforceable. Further, getting paid may be cold comfort, as the unregistered broker-dealer later could face regulatory action or litigation from unhappy investors.
4. The Good News – How to Stay out of Trouble:
Now that you know what types of arrangements do not work and what could happen if your finder is acting as an unregistered broker-dealer, here are some activities that finders can do without running afoul of the broker-dealer registration requirements:
- Make introductions (i.e., provide names and contact information). Introductions may only be made to prospective investors who the finder has a substantive and pre-existing relationship with and where the nature of the relationship enables the finder to be aware of the financial circumstances or sophistication of the prospective investor, or is otherwise of some substance or duration.
- Help prepare offering materials, such as executive summaries and placement memorandums. Note that the finder may not present such materials to investors or negotiate such materials.
- Help with administrative matters.
- Receive a fixed fee or hourly compensation, so long as it is not contingent upon (or tied to the success of) an investment being made.
- Many startups fail – that’s true. But, if you want to achieve long-term success, you should be careful not to engage a finder acting as an unregistered broker-dealer in order to avoid these significant legal and regulatory issues. In reality, most finder arrangements do not stand up under proper legal scrutiny. So what to do about it?
- First, make sure the person or firm that you are working with is credible. Life is too short to deal with unregistered broker-dealers that don’t add value.
- Second, avoid transaction-based compensation and other broker-dealer activities or at least be aware that your arrangement may not hold water and understand the risks.
- Third, make sure you have a consulting agreement in place with the finder, documenting your relationship and specifying what the finder is expected to do and, importantly, what the finder is prohibited from doing.
There are a range of “finders” out there in the startup world, so be thoughtful as you evaluate your financing opportunities and the people who will help your company raise money. And remember that raising money is serious business and the investors are not the only ones taking on risk with the financing transaction.
Are you familiar with raising money with the assistance of a finder? What was your experience?