Entrepreneurs trying to raise capital to grow a business frequently run across individuals describing themselves as a “finder” and offering to help them structure a private offering and sell that offering using their contacts. They will typically ask for limited or no up-front compensation but will take a percentage of the money raised. This practice is so prevalent that it is clear that most entrepreneurs, and often the finders themselves and the lawyers involved, are unaware that these services are illegal unless that person is properly licensed. Even if aware of the licensing requirements, most are unaware of the potential criminal and financial consequences for not just the finder and the company, but also the company’s directors and officers.
The Licensing Requirement. The source of the requirement that finders be licensed is the prohibition against any person acting as “dealer” without first registering as such under state of federal laws. Generally, a dealer is defined as “any person engaged in the business of effecting transactions in securities for the accounts of others.” A narrow and superficial reading of this definition often leads finders and some attorneys to claim that the finder is exempt from registering because their services don’t fit this definition. In fact, historically, SEC no-action letters have lent support to a very narrow reading of the “dealer” definition and given rise to the wide-spread belief that there exists a so-called “finder’s exemption.”
However, in recent years, the SEC and most states, including Ohio, have indicated that they now interpret this definition very broadly. In general, if any of the following are involved, the conduct will likely trigger the licensure requirements:
- The finder participates in important parts of a securities transaction, including soliciting, negotiation or executing the transaction.
- The finder discusses with the investor the details of an offering or makes recommendations as to the suitability of the securities being offered.
- Compensation of the finder depends upon, or is related to, the outcome or size of the transaction. (The SEC has indicated that the presence of “transaction-based compensation” is the most significant factor in determining that a finder must be licensed).
- A history of the finder effecting or facilitating securities transactions.
- The finder handles the funds relating to the transaction.
So in reality, the “finder’s exemption” is limited to a scenario where a person a flat, up-front fee for nothing more than an introduction and that person does not have a history of receiving fees for making those types of introductions. Obviously this arrangement is not generally practical because it involves too much risk for the entrepreneur and would not be available for the a professional finder. (Note: Even this arrangement poses risks and the analysis is very fact-dependent; so please don’t rely on the above statement without consulting an attorney knowledgeable in this area for each transaction.)
Not only has the SEC and state enforcement agencies reading of the law become much more strict in recent years, unlicensed finders are also much more likely to get caught. 2008 revisions to Form D (the form that must be filed to utilize the Reg D private-placement exemptions) now require companies to disclose fees paid to finders, making policing these activities much easier for regulators. Representatives of the Ohio Division of Securities have recently stated that they monitor Form D filings and follow up with requests for licensing information when the form indicates commissions have been paid.
The Consequences of Using an Unlicensed Finder. Unlicensed finders are subject to civil and criminal penalties under both federal and state laws, and their compensation agreements would not be enforceable in court.
Arguably, though, the consequences are potentially even more severe for the company. The use of an unlicensed finder will subject the issuer to regulatory action by authorities and the SEC, will nullify the Reg. D private-placement exemption and give all investors in the current round the right to rescind their investments. Using an unlicensed finder in an early round will also make it much more difficult to raise capital in future rounds. The SEC may prohibit the company from using the private placement exemption in future offerings, limiting its ability to raise capital from private investors, including angel investors and venture capital funds.
Even if no additional funds are needed, the ability for the founders to exit will be jeopardized. Public offerings will be significantly more difficult because of additional legal and accounting concerns and because the SEC may even require the previous financing round to be rescinded prior to the company going public. Securities violations may also derail an acquisition or at least significantly decrease the price paid by the acquirer.
Finally, most state laws, including those in Ohio, state that the persons liable if the investors seek their money back (together with their statutory interest and attorneys fees) are not only the company but its directors and officers, as well as those involved in selling the securities.
Calls for Change. The current state of the law poses significant problems for startups seeking to raise capital. Given the nature of a “private offering”, they often don’t have any way of getting in front of enough accredited investors to successfully sell their offering. And because the size of the offering typically sought by early-stage startups is relatively small (under $5,000,000), they often have a difficult time attracting the attention of the registered broker-dealers.
The American Bar Association conducted a study of this issue in 2005 and recommended the creation of separate and easier-to-obtain category of licensure for “money-finders”. In addition, there are legislative proposals in several states that seek to address this issue. However, movement in this area has been slow, and the SEC has not indicated that addressing these concerns is a high priority. Until they do, startups raising capital are well-advised to avoid unlicensed finders.