Welcome everyone to another edition of the Global Tech Law Newsletter! Today’s topic may seem a bit obscure to some, but for those in the startup, VC, and M&A world, it will be quite familiar. The use of brokers/finders to help companies find buyers or investors.
For example, the owners of a closely-held, small or mid-market private company are looking to retire and sell the business. They engage someone with a large network to help them find a buyer.
Or a startup looks for someone to help them raise funding from outside investors for a new financing round.
If you want to get third party help for fundraising, the safest thing to do is to engage a licensed “broker-dealer.” But because in the U.S., broker-dealers have to register with the SEC and with the Financial Industry Regulation Authority (FINRA), hold membership there, and demonstrate certain experience and expertise to get and maintain those registrations, they typically charge a fee for their services that can be prohibitive for small companies – upfront/monthly retainer + a commission on any transaction. Moreover, a traditional broker-dealer may simply not want to take on small company clients without a retainer and significant enough transaction size to make the commission worth the effort. (Note these broker-dealer type of rules show up in similar form in many other countries as well.)
In such cases where a startup can't engage a traditional broker-dealer, these companies may be tempted to rely on a more informal network of connectors and other acquaintances to help them raise funding. And despite the legal issues, this does happen quite often with companies either knowingly taking the risk or more likely unaware of the problem in the first place. It may be less common in Silicon Valley where paying someone to help you fundraise might be seen as a sign of weakness and desperation -- and where companies often engage more general, individual advisors and compensate them with advisor equity for overall advice instead of just for fundraising with payment in cash.
So when do you really need to work with registered broker-dealers, and what are the potential ramifications if the SEC, for example, feels the work should be covered by broker-dealer regulations?
First thing to understand is what a broker-dealer can do.
A broker-dealer participates actively in structuring, negotiating, and executing transactions. Some part of their fee is typically a commission and therefore contingent on the transaction happening. Broker-dealers are regulated by the SEC, FINRA, and must comply with anti-fraud rules such as SEC Rule 10b-5, as well as state Blue Sky Laws.
A finder on the other hand, merely makes introductions. They don’t play a significant role in negotiations, and they do not take commissions but instead merely flat, one-time introduction fees. The key is that the fee is not contingent on raising funds from the person they introduced to you.
Can we have someone we know, “Johnny”, help us raise funds? Well are you paying him a monthly fee for advice on how to raises funds? Or are you paying him for introductions and paying him based on how much the investors close for and only if they close?
The latter… what’s the big deal?
Well first Johnny runs the risk of penalties, fines, and giving back all the fees he’s received. More importantly, the company risks having the transaction be unwound later and the investors getting their money back. And that is a risk that continues to hang over the company (especially if the company hits some development speed bumps), particularly as each new round of investors come in.
The current round investors and future round investors will ask the company/founders to represent in the investment documents that no finders or unlicensed broker-dealers were used. Having to disclose these individuals after a term sheet is signed and a price agreed to is not a fun experience. Not disclosing them runs all kinds of legal risks. And thus it is essential to:
(1) Limit people who help you raise funds to (ideally) registered broker-dealers.
(2) If they are not available, limit finders to introductions only and flat-fee, one-time payment. Absolutely, do not involve them in negotiation of terms.
(3) Be forthright in disclosing the use of these individuals to investors during the due diligence process.
Remember, the most important thing to be mindful of among everything discussed above, is compensation cannot be variable and dependent on the transaction closing. That is the clearest risk of someone being deemed a broker-dealer requiring SEC and FINRA registration. It’s hard to turn down potential avenues to funding, but you don’t want to create an albatross hanging around the company’s neck either. Trust me, you’ll sleep better at night.
Okay that’s it for another edition of my Global Tech Law Newsletter. See you back here again in a week!
*This blog may be considered attorney advertising. It is for informational purposes only and does not constitute legal advice.