When a startup is receiving professional assistance in raising neededcapital to continue growing the business and the brand, a common issue arises – whether the startup is allowed to compensate the individual helping raise capital with a commission or transaction-based fee if he or she is not a licensed broker dealer. Here is the answer: generally, no. This type of compensation structure is not allowed. Specifically, the use of an individual who is not a licensed broker-dealer to assist in raising capital is considered to be a violation of federal and state securities laws.
It is also not recommended due to serious risks posed by individuals and companies offering such services to your startup. Why? As mentioned above, the majority of individuals seeking a fee to help startup businesses raise capital (commonly referred to as a “finder”) are not licensed to engage in such activities. The lack of licensure means there is not much oversight and could expose your startup to paying a large sum to someone who does not have your startup’s best interests at heart.
What Exactly is an Unlicensed Broker-Dealer?
A “broker-dealer”is a person who is engaged in the business of effecting transactions in securities for the account of others. The Securities and Exchange Commissionuses a four-factor test to determine when a “finder” is required to register as a broker-dealer:
- Whether the person receives commissions or other transaction-based compensation;
- Whether the person makes buy/sell recommendations and provides investment details;
- Whether the person has a history of selling securities (regular activity); and
- Whether the person takes an active role in negotiations between the investor and the issuer.
Possible Liabilities
When a startup utilizes a finder, the founders of the startup are exposing themselves to liability under both federal and state law. Agreements for the sale of securities made in violation of federal law may be held void and subject to rescission. This would likely apply to an agreement with an unregistered broker who attempts to collect a fee for assisting in the sale of the securities. In addition to a federal violation, there are several states that have similar rules on the books.
Potential Ramifications
If a startup founder, or founders, decides touse the services of an unregistered broker-dealer to help raise capital, there are some serious potential ramifications. Those ramifications may include:
- Enforcement action brought by the SEC as an aider and abettor;
- Enforcement action brought by state securities regulators; and
- Be prohibited from participating in, or being involved with, companies that do a securities offering made under various securities exemptions.
In addition, the startup could be prohibited from filing a Rule 506 securities offering, which is the most commonly relied-upon securities exemption for startups and emerging growth companies.
Thus, if you get a call from someone offering to help raise capital for your startup in exchange for a fee, it is in your best interest to decline the offer.
Recent SEC Proposed Rule
Notwithstanding the foregoing, on October 7, 2020, the SEC proposed rules which would exempt certain categories of finders and provide greater clarity regarding the permissible activities of finders who are not registered broker dealers. This new exemption would create two classes of natural person finders, Tier I Finders and Tier II Finders, which would both be permitted, without broker registration, to engage in certain capital-raising activities and accept transaction-based compensation if they each meet conditions and limitations tailored to the scope of their respective activities.
Tier I Finders
A Tier I Finder would be limited to providing contact information of potential investors in connection with only a single capital-raising transaction by a single issuer in a 12 month period. A Tier I Finder may not have any contact with potential investor about the issuer.
Tier II Finders
A Tier II Finder could solicit investors on behalf of an issuer, but the solicitation-related activities would be limited to:
- identifying, screening and contacting potential investors;
- distributing issuer offering materials to investors;
- discussing issuer information included in any offering materials, provided that the Tier II Finder does not provide advice as to the valuation or advisability of the investment; and
- arranging or participating in meetings with the issuer and investor.
Conditions for Both Tier I and Tier II Finders
The proposed exemption for Tier I and Tier II Finders would be available only where:
- the issuer is not required to file reports under Section 13 or Section 15(d) of the Exchange Act;
- the issuer is seeking to conduct the securities offering in reliance on an applicable exemption from registration under the Securities Act;
- the finder does not engage in general solicitation;
- the potential investor is an “accredited investor” as defined in Rule 501 of Regulation D or the finder has a reasonable belief that the potential investor is an “accredited investor”;
- the finder provides services pursuant to a written agreement with the issuer that includes a description of the services provided and associated compensation;
- the finder is not an associated person of a broker-dealer; and
- the finder is not subject to statutory disqualification under Section 3(a)(39) of the Exchange Act, at the time of his or her participation.
Further, a finder could not:
- be involved in structuring the transaction or negotiating the terms of the offering;
- handle customer funds or securities or bind the issuer or investor;
- participate in the preparation of any sales materials;
- perform any independent analysis of the sale;
- engage in any “due diligence” activities;
- assist or provide financing for such purchases; or
- provide advice as to the valuation or financial advisability of the investment.
Additional Conditions for Tier II Finders
Because Tier II Finders could participate in a wider range of activity and have the potential to engage in more offerings with issuers and investors, additional, heightened requirements have been proposed. A Tier II Finder wishing to rely on the proposed exemption would need to satisfy certain disclosure requirements and other conditions. These disclosure requirements include providing appropriate disclosures of the Tier II Finder’s role and compensation prior to or at the time of the solicitation. Further, the Tier II Finder must obtain from the investor, prior to or at the time of any investment in the issuer’s securities, a dated written acknowledgment of receipt of the required disclosures.
Note that the Finders Exemption would not alter a finder’s obligation to comply with all other applicable laws, including the anti fraud provisions of the Securities Act and the Exchange Act and state law.
Potential Impact and Status.
While the SEC states that the proposed Finders Exemption is intended to help small businesses raise capital, the Finders Exemption Proposal does not materially limit the issuers or size of offerings that may use finders relying on the proposed Finders Exemption. Specifically, although the proposed Finders Exemption is limited to accredited investors and private transactions, there was no discussion in the proposal regarding an overall cap on funds raised, making possible for larger issuers or larger offerings to use a finder under the proposed Finders Exemption. Furthermore, the proposed Finders Exemption would be available to private, non-reporting companies. This could potentially extend the benefit of the proposed Finders Exemption to private equity and venture funds raising capital.
Over a year has passed and we are still waiting for to find out whether the SEC will issue the exemption as proposed or in modified form,or withdraw the proposal.
Have Questions? Contact an Experienced Startup Lawyer in Los Angeles Today
If you are seeking an experienced and highly reputable startup lawyer in Los Angeles, the professionals at Hakim Law Group are here to help. HLG represents an array of entrepreneurs, operating companies, venture capital firms, and financiers in the education, fashion, finance, health care, internet and social media, technology, real estate, and television industries. Whatever business issue you need addressed, the professional business attorneys at Hakim Law Group are here to help. For further information or to schedule an appointment please contact HLG at 310.993.2203 or visit www.HakimLawGroup.com to learn more.
