Part III) Finder’s Fees-
So you have a great idea, founded a company, and you are telling your friends and family about it. It is difficult to succeed without some working capital, i.e. cash in the bank. If you are new to startups or haven’t had to worry about raising money before, you suddenly are introduced to a new world of people who claim they have very rich friends or “know people.” They would love to help you raise some money, but they want a piece of the action. They may ask you for a percentage of the cash their “people” bring in, a percentage of equity in your company, a job with your company, or maybe some combination of these. So what can you do to compensate someone who claims to be able to bring you in anywhere from a few thousand to many millions of dollars in funding?
This is a very common problem that founders and early startup companies face. Here are some common questions:
- What the “norm” is for these types of deals? None, if done, they vary widely on circumstance.
- What percentage of equity should I give them? Probably not a big deal what you give as long as you still retain control of the company and are allowed to dilute them down in the future
- Should I use options instead? Possibly.
- Should I just give them cash? Probably not.
- Am I wasting my time with this person or can they really can bring in the dough? Probably.
- Should they sign some kind of non-disclosure agreement (NDA) or other legal document? Probably, yes.
- Are there any risks to me or the company if I go with this person? Yes, even if they are licensed or registered to be a broker/dealer.
- Can I pay my employees or bring the finder on as a VP to pay them a finder’s fee? No, that doesn’t really change the analysis of whether it is legal if it is a percentage of the raise.
I will discuss the legal issues associated with finder’s fees and the bottom line, starving company CEO point of view, as well.
A) Legal Issues with Finder’s Fees
The core issue comes down to the fact that you may not think about it, but you are trying to sell a security. You or the finder will be offering and selling stock or some form of ownership in your company. A “security” is defined by the Securities Act as any note, stock, treasury stock, bond, debenture, evidence of indebtedness, and numerous other transactions. So, even if you do a debt finance deal, that is still the sale of a security, i.e. the promissory note or other evidence of indebtedness. Anyone who receives a commission or compensation from that transaction is normally considered a broker-dealer in those securities since they are making their money from trying to sell the security. There are state and federal regulations on broker-dealers, the most relevant of which is that they must be licensed/registered with the appropriate regulatory agency. The SEC and states have their own registration or licensing regulations and procedure.
When you think of your big bank brokerage account and think about the investment advisors and similar roles within them, that is normally a licensed broker-dealer. Just because it is you or a finder out trying to raise money for your small startup company and not selling shares of Microsoft, that doesn’t mean that broker-dealer regulations aren’t still in play. As the issuer (company selling the securities) and its personnel (CEO, CFO, etc.), you are probably not in the business of buying and selling securities and do not need to be registered or licensed to raise money just for your business; however, the finder often is under those obligations.
There are some limited exemptions provided so that an un-registered person may still engage in the buying or selling of securities. They are too technical to go into detail, but there are exemptions for certain intrastate transactions, for personnel of the company in offering their own securities for sale (although they cannot be compensated with a commission based upon those transactions to fall within this exemption), and some others. The law is very specific about the requirements for insiders to use these exemptions. For example, you cannot simply hire a finder as an employee or officer of your company, have them raise money, and then let them move on. They can’t be paid a commission on the transaction amount, even if they work for you, must perform substantial duties for the company outside of raising money, and can only use this exemption generally once every 12 months.
There are also disclosure requirements and other things that a licensed broker/dealer must comply with to comply with the law. A finder would technically be subject to those if they are required to be registered. As the issuer, you can face liability for fraud through misrepresentations, omissions, or blatant lies made by the finder or anyone else you send out there to raise money.
Legal Risks in Signing with a Finder
Assuming the finder is not licensed or registered with the appropriate agencies and does not fall under an exemption from registration, the finder can be held liable to the person who purchased the security (the investor) for the amount paid, as well as possibly subject to civil penalties to the regulatory agency and possibly face criminal liability. These actions can be taken by the state or federal agency in charge of regulation, or possibly both. Although I am not an expert on the civil or criminal ramifications for issuers (company) and its management, I can see potential aiding and abetting the crime of selling securities without a license. Also, the issuer and management can be held liable for recklessly made hype about the company, its prospects, financial condition, and a variety of other items. This could come in the form of shareholder lawsuits, SEC or related agency civil or criminal prosecution. For example, in California, under Corporations Code Section 25501.5, the investor has the right to rescind (cancel) the investment and seek damages against the unlicensed person (finder). Generally, that would mean the finder has to give them their money back that they invested and could face additional damages. However, this section does not directly impose liability on the company, but that doesn’t mean a plaintiff’s lawyer won’t try to sue the company and its management.
The majority of the risk falls on the actual finder and many self proclaimed “finders” are not even aware of the fact that they are doing something that may require registration or licensing as a broker-dealer. However, a loose cannon out promoting your company and making all kinds of promises about how good of an investment it is or anything along those lines can take the company and its management down into potentially major risks for the company and the persons involved.
In California AB 2167 was implemented in 2005 to add penalties similar to federal remedies for rescission of the purchase, monetary damages, and longer statutes of limitations to bring claims. The SEC has used a number of factors to determine if the activity is something they consider wrong in no-action letters such as:
(1) involvement in negotiations; (2) discussion of details of the nature of the securities or making recommendations about the transaction; (3) transaction-based compensation (i.e. commissions); and (4) previous involvement in the sale of securities.
The more those factors are present, the more likely the SEC is to consider it activity requiring a license.
B) Bottom Line Starving CEO View
I have worked in the trenches and can tell you that when your company needs cash to survive and grow, you tend to forget about the legal ramifications and just want to get to that right person who is going to get you the cash. I am not telling you to forgo the law and do whatever you want, but knowing the risks, each startup exec needs to make the decisions to move forward or not. I have worked within companies where it paid out equity and cash and signed many finder’s fee agreements usually anywhere from 1% to 10% typically, sometimes more. It was paid in cash, equity, options, or a combination. In some cases, the finder’s fee was even disclosed in public filings with the SEC and audited financials/footnotes. The SEC, SIPC, or any other regulatory agency did not come and knock our door down and take everyone away in handcuffs. That isn’t to say that you couldn’t be arrested and charged by the SEC with some form of fraud or other crime if your finder was out there over-hyping your company. There are risks associated with these deals, but usually that would come in the form of lawsuits by unhappy shareholders who invested through these finders.
Some quick pointers if you do decide to take on a finder’s fee arrangement:
If the person or organization is one that normally raises money for companies (e.g. investment banker), they are probably or should be licensed broker-dealers and can receive a commission, success fee, or other arrangement, so go with those first if they are currently licensed and put it in writing. This is not to say you should just blindly sign on with them. There are still risks if the person doesn’t comply with any disclosure requirements or makes fraudulent or misleading claims about the company or its future, so be sure you have checked them out and they are reputable.
Don’t accept everything they say as accurate. Many finder types are natural salespeople and can be a good asset to talk up your company, but they are notorious for what many call “puffery” or exaggerating the facts to make something sound better than it is. Whether licensed or not, a broker-dealer or finder can be liable, as well as the company and potentially management, for material misstatements, omissions, misrepresentations, and outright lies by this finder. Think of the examples from the media about “boiler room” operations and avoid those like the plague.
Do try to protect your company by putting something in writing. At the very least, get a good non-disclosure agreement in place with non-compete, non-circumvention language to the extent that it is enforceable in whatever state or place where you are raising money. You can at least try to let them know you are not going to let them try to steal your ideas, plans, or other intellectual property
There are ways to draft finder’s fee agreements to, at least in writing, limit the extent of what the person can and can’t do or say when out there trying to bring in investment dollars. This way if things go bad, you can at least have something you can point to in court to show that you made it clear that they could only do and say certain things. These won’t stop the SEC from pursuing fraud, criminal or civil claims against you or your company, but it is a way of trying to limit exposure. I always advise clients of the potential major risks for the company, management, and the finder before pursuing any form of finder’s fee agreement.
Be clear to limit what the person can and can’t do and make it a non-exclusive relationship. Don’t promise them some future board seat or CEO role, limit it to the transaction at hand. Be clear that they are there to provide introductions only to people that may be a potential investor. The least risk is to only get the name and contact info for the potential investor and then have management deal with follow up. Be sure the finder is not out doing road shows or hyping your company on their own. Have them provide their investor contacts in writing and when they were referred to the company. Also, don’t agree to an “exclusive” finder or similar arrangements if you can. An exclusive finder is one who can be a real pain if you bring in money from elsewhere and there is a fight over where the money came from. When you stick with non-exclusive, it puts the burden on them to be sure they document that it was their contact and could avoid litigation.
Assume the person will not come through. Unless you have some connection, relationship, or prior experience with this person that has proven their worth, don’t rest your company’s future on one person who is probably working on 100 other companies through finder’s fee agreements. They are out for their bottom line, just as you should be with your company. Keep working on other ways to raise the money yourself.
Don’t worry so much about some exact percentage of cash or equity to be agreed upon. Do agree on something from the start so that everyone knows going in. The capitalization of the company is going to change so many times in the company’s evolution that 10% of equity now will probably be 0.001% later.
In the end, it is up to each company and their executives or board to make these kinds of decisions based upon risk versus reward. You also need to think about it this way, if this person is so well connected and believes in your company so much, ask them to put their own money into the company. I know a lot of people in the finance and legal world will tell you just not to do this in any event, but I am aware of the challenges of being management in a company that needs those funds to grow, so I will tell you that the best option is to avoid these relationships, but if you do enter into them, try to limit your potential downside risk and seek out some legal guidance in moving forward.
There are discussions these days of a so-called “intermediary” who is essentially a finder. The JOBS Act includes provisions that deal with intermediary use and compensation. The SEC is implementing rules to put the JOBS Act provisions in place, but the use of intermediaries is limited to the specific provisions and ways it is listed in the JOBS Act only and states have not taken any action in this regard although most of the JOBS Act is supposed to trump state law.
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Legal Disclaimer: All answers and discussions in this article are meant to be general and educational in nature only and should not be relied upon as legal, business, or tax advice for your specific situation. Most discussions refer to laws and regulations as applied to a California corporation and these can vary by location, as can other factors in certain situations within California, so it is always best to consult with a licensed local attorney with experience in these matters. Use of, or any discussion as a result of these articles does not create an attorney-client relationship and is not governed by rules on confidentiality.