Two things founders don’t have a lot of are time and money. Raising capital can be a challenge for any size company, but more so for startups, whose initial financial needs could be larger than what family and friends can invest, but smaller than what would typically attract larger venture capitalists. When the runway ends, the company could fail – and in fact, lack of runway is the second-most-common cause of startup failure.
Finding potential investors is time consuming, and this task can be far outside a founder’s wheelhouse. To fill that need, founders may turn to either a professional broker or to a growing number of “finders” who seek out potential investors on behalf of a company in exchange for compensation. But while the terms broker and finder may often be used interchangeably, they actually provide two separate levels of service.
A “finder” does just that – finds a potential investor and introduces that investor to the company. The finder receives compensation contingent on a successful raise and, as such, may be subject to both state and federal securities regulations.
A broker is involved in all steps of the process: finding and introducing eligible investors; providing advice and participating in discussions between the company and potential investors, and then working with the company to close the deal. The broker receives compensation that is contingent on the closing of the sale and may be based on a percentage of the total amount of capital raised. Because the broker is involved in the process of issuing securities to investors, he or she is expected to register with the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), as well as comply with Blue Sky laws.
The Company’s Risk
Founders looking to lower their overhead or speed up the fundraising process might consider engaging the services of an unregistered broker or finder. But that can turn out badly; here’s why:
A broker or finder—registered or not—who knowingly or unknowingly violates federal or state securities regulations can be subject to civil and criminal penalties. Companies which issue securities illegally could inadvertently give the investor who purchased those securities a right of rescission against the company for a period of up to five years (depending on the state). Additionally, the company could lose its ability to raise under Regulation D in the future, which would all but eliminate them from the race to receive funding. Even if the company avoided the civil or criminal penalties connected with aiding and abetting a violation of securities laws, it could still ruin its reputation in the venture capital community. In the highly competitive venture capital space, founders need to mitigate as many risks as possible.
Registering brokers with the SEC and finders with state agencies serves the same purpose as registration and licensure in any industry—to provide a level of oversight, safety, and security to consumers. All companies should thoroughly investigate the credentials and work history of any broker or finder before working with them, but having the proper credentials increases the odds that these individuals know how to do the job within the law, and lowers the risk that a company will align itself with a known ‘bad actor’ with a history of questionable business practices. Besides that, if a broker or finder doesn’t want to register with the SEC or state authorities, that might be all the information a founder needs to stay clear.
Broker or Finder?
Registration requirements for brokers and finders vary widely by state, with some allowing exceptions related to limited types of broker activities. Some states, including California and Texas, register brokers and finders through separate pathways. Massachusetts, on the other hand, is among the states that require finders to register as brokers regardless of their level of interaction with issuers. If you are considering issuing securities by using the services of a broker or finder, check with your attorney to see what state requirements may apply.
If someone performing only finder activities isn’t registered with the SEC (or alternatively, if they aren’t registered with the state that offers a path to such registration), can a company also get in trouble? This is still a gray area, as a “finder” is not defined under federal securities laws – the SEC has only provided limited guidance on activities that may not fall under the definition of a broker, so registration under state law may not prevent enforcement action under federal law. Note that the SEC advises anyone whose business activities might be construed as that of a broker – which may include activities more closely resembling a finder – to carefully assess what kinds of services they plan to offer and how they expect to be compensated before soliciting business.
In October 2020 the SEC proposed an updated regulation intended to more clearly define the roles of finders as compared with brokers. With the proposed change, finders would be categorized into one of two tiers based on the scope of their work and their level of involvement; as long as finders confine their business dealings to within their tier they would not need to register with the SEC. To date the SEC has not yet issued a final ruling on this proposed regulation. Even if this new rule does take effect, state registration requirements may still apply.
Using the services of a broker or a finder can be a good option for founders who find themselves unable to dedicate enough time to raising capital – just make sure he or she is properly licensed with appropriate regulatory authorities. Consider also that a company will go further if it has good advisors, and many advisors are also well-connected to venture capital firms and other eligible investors. Given the choice, an organically formed connection to capital is always a better option for the busy founder.
Bob Baker is a founding partner of Peak Corporate Counsel. He has worked with numerous founders on a variety of issues specific to startups. When he’s not advising innovators, he can be found at networking events, playing rugby, or hiking with his kids. Contact Bob.
This article is for informational purposes only, and may not be considered legal advice.