Raising capital is tough. No doubt about it. The process of locating angel and/or venture capital dollars can last longer and be more difficult in current markets than most entrepreneurs or startups expect.
Enter Finder:
“I am well connected. In fact, my rolodex is stellar. I can introduce you to my stable of wealthy investors. When one of my referrals invests in your company, you pay me a percentage of the amount raised. That way, we all win. Bartender: another round…”
Entrepreneur to Attorney:
“Can you take a quick look at the this Consulting Agreement? I want to sign it as soon as possible so that we can go after funding. We’ve already agreed on the finder fee (6% of the amount raised plus equity), so just make sure that it is ok to sign.”
Attorney to Entrepreneur (abbreviated, of course):
“Well, the nature of the relationship appears to be problematic from a securities law standpoint…I would advise against engaging Finder because Finder appears to be acting as unregistered broker-dealer, which is a violation of securities laws.”
Entrepreneur to Attorney:
“What? Finder has been doing this for 10 years and has never had a problem. We need to raise money quickly, and Finder can help us do it. Finder has been involved in several transactions with big-time investors/companies. Moreover, I like Finder, and Finder understands our business. Figure out how to make this work! [Attorney, maybe you’re not seeing the forest for the trees, you know -- the larger, business picture.]”
Comment:
In this illustration, Attorney is not being a party-pooper. Rather, Attorney is trying to guide Entrepreneur away from a securities laws violation for for engaging a “finder” who should have been registered as a “broker-dealer.”
If Entrepreneur were to engage Finder as described above, Entrepreneur might be subject to civil and criminal penalties, rescission of the investment (the investor could get its money back), and potential liability for aiding and abetting an unregistered broker’s fraud. Moreover, if Entrepreneur sold securities pursuant to a private placement exemption from registration, Entrepreneur might lose that exemption as well.
Very serious stuff.
Finders and Broker-Dealers
Third parties who assist entrepreneurs in raising capital are generally classified in two different ways from a legal perspective: a “finder” or a “broker-dealer.”
Federal securities law defines a “broker” as any person engaged in the business of effecting transactions in securities for the account of others. A “broker-dealer” is a person who helps an issuer of securities to locate investors and to sell securities, and who is registered as a broker dealer under the federal and applicable state securities laws.
A “finder,” on the other hand, is a person who helps an issuer of securities to locate investors, but is not registered as a broker-dealer under the federal and state securities laws.
Finder Limitations
Broker-dealer laws were enacted in order to protect investors. Broker-dealers must meet standards of conduct established by the Securities and Exchange Commission and the Financial Industry Regulatory Authority (FINRA). Because finders are not subject to such regulation, the participation of finders is restricted in the context of securities transactions.
Unfortunately, all guidance on finder issues comes from SEC no-action letters. Without settled, clear interpretation of what constitutes permitted finder activity, many finders unlawfully engage in broker activity without registration. Issuers of securities should be alert when engaging finders, as securities regulators may pursue unlawful activity without regard to whether such activity was intentional or erroneous.
What Can Finders Do?
The SEC has established (in several “no-action” letters) that finders can engage in certain limited fundraising activities as a result of an exception to broker-dealer laws. The list of permitted activities is short and very narrow, and includes functions such as identification of sources of capital, preparation of business plans, and the provision of certain financial consulting services. An issuer must be vigilant, however, ensuring the finder does not exceed the parameters within which a finder may lawfully act without registration as a broker. A general rule is that the role of a finder in a securities transaction ends once an initial introduction is made.
In the scenario described above, the SEC would likely determine that Finder is acting as an unregistered broker-dealer, because Finder’s compensation is directly tied to successful investments in Entrepreneur’s securities. The SEC has repeatedly stated that the presence of transaction-based compensation is one of the most important factors in determining whether broker-dealer registration is required.
Can Entrepreneurs and Businesses Use Finders Legally?
Yes, but with caution.
Capital seekers should first recognize that engaging a finder who should be registered as a broker-dealer is not only a problem for the unregistered finder, but is also a potentially serious problem for the issuer of securities.
If the finder’s registration as a broker is not feasible, then a written agreement with the finder is imperative.
Any such agreement with should explicitly describe the finder’s role, enumerate the finder’s permitted and prohibited activities, document the finder’s compensation in detailed terms, and include an acknowledgment by the finder of an awareness of broker-dealer laws.
Within the private equity/venture capital world, raising capital through finder-type relationships is commonplace and often the only avenue to financing emerging businesses. Whether the SEC will ever respond to this reality with constructive regulation addressing issues surrounding finders is unknown. What is clear, however, is that advice from competent legal counsel is critical for guidance regarding finders and securities law compliance when engaging third parties and raising capital.
How does one go about finding a registered broker/dealer who finds and secures private funding under Reg D Rule 506 for featire films in the range of $20-40 million?
Can’t tell you how to find brokers, but you can check via FINRA to determine whether registered.
No wonder the % of people unemployed is going up and up endlessly!!!!!!! With friends like that in our own economy, who needs enemies? We need the SEC to help entrepreneurs raise money and as long as the money is clean and the investor(s) agree to the Finder’s Fee being paid and the investor is protected, what should the SEC care about how much money the entrepreneur and the investor are willing to pay for putting them together? Many times a great deal does not happen, unless the right person introduces the entrepreneur to another right person, like in the case of Paul Anka, who all he did was make an introduction and was NOT competing with broker dealers at all.
Yes, I agree. Perhaps there should be some kind of exception for smaller transactions, since most smaller companies and entrepreneurs only find funding through these kinds of introductions.
It is already difficult to find funding, and these SEC rules seem to make it a lot harder.
So…if the SEC uses compensation to define a BD, how do you legally compensate a “Finder”, without them having to be a licensed/registered BD?
Compensation is just one of the factors that the SEC uses to evaluate whether broker-dealer registration is/was required, along with the nature and scope of the finder’s activities and services. Again, the one of the most important factors in this analysis is whether the compensation is a commission or transaction-based.
If a “finder” has a Series 7 & 63, can he register with a BD and then become a broker, free to accept a transaction based fee and avoid all of these issues? If he does use this arrangement, under what legal entity can he do business under? Does he have to use the name of the BD? or can he create an LLC? someone said he would have to use a trade name, but not sure what that means.
Specific registration requirements are promulgated by the SEC, self-regulatory agencies (such as FINRA), and applicable state securities regulators.