by Matt Storms and Paul Page
Small businesses often have challenges with raising capital from investors. Gaining access to equity capital can be difficult and complying with a myriad of rules and regulations when seeking help in raising funds can be very confusing. When raising equity capital, many entrepreneurs seek assistance from unlicensed “finders” for introductions to potential investors. Recent government enforcement actions and commentary from regulatory agencies, however, emphasize some of the risks associated with working with unlicensed finders.
So . . . What do Finders Find?
Generally, finders make introductions between investors and companies, but do not actually sell securities or close transactions on behalf of the companies selling the securities. If a finder is providing anything more than a simple introduction or access to contact information, or is receiving a fee based on the completion of a transaction, then the finder needs to be licensed as a broker-dealer.
Finders are generally not allowed to pitch for the company, develop deal terms, or negotiate for or represent the company, unless they are licensed as broker-dealers. Both state and federal law require anyone who is involved in the business of selling securities to be licensed. If a company uses the services of an unlicensed finder when a broker-dealer license is required, then (1) the company may be at risk for civil and criminal penalties; (2) the investors may be able to rescind their investment transaction and demand their money back; and (3) the company’s ability to raise capital in the future may be limited. If the management of a company desires to have someone help develop deal terms for them, have someone pitch for or with them, and receive compensation for those or similar services based on a successful capital raise, then the company will likely have to engage a licensed broker-dealer.
Regulation of Broker-Dealers and Finders
The regulation of broker-dealers was instituted under state and federal law to protect potential investors from abusive and misleading sales practices. Broker-dealers are required to conduct a reasonable investigation into both the securities that they offer and the issuers of the securities. They also are required to evaluate whether the securities are suitable for the investors purchasing them. By categorizing finders as broker-dealers, regulators are attempting to prevent them from engaging in the abusive and misleading sales practices that securities regulations are intended to curtail.
There is no specific “finder’s license” issued by the U.S. Securities and Exchange Commission (SEC), and obtaining a state and federal securities license to become a broker-dealer is a significant burden; moreover, most of the requirements to obtain the license has little to do with what finders actually do. Most finders are well-connected people who only occasionally make introductions of companies to potential investors, so taking securities exams, meeting ongoing securities-related educational requirements, and being subject to the oversight and monitoring of a broker-dealer’s compliance department is generally not worth the hassle to them.
Recent Developments: Finders under Fire
Over the past few years, the SEC and state securities regulators have been more aggressively enforcing restrictions on the activities of unlicensed finders. On May 17, 2010, the SEC denied a request from a law firm seeking a “no-action letter” related to the law firm’s proposed introductions of a client to individuals who “may have an interest” in investing in the client, where the law firm would receive a small percentage of the investments made as a result of the introductions. In its response, the SEC stated that “transaction-based compensation” is a “hallmark of broker-dealer activity” and that “any person receiving transaction-based compensation in connection with another person’s purchase or sale of securities typically must register as a broker-dealer or be an associated person of a registered broker-dealer.” Additionally, the SEC stated that a finder who is introducing people who may be interested in buying securities would likely be both “pre-screening potential investors to determine their eligibility” to purchase the securities, and “pre-selling securities” to gauge the investors’ interest. The SEC concluded that compensation tied to successful investments would give the law firm a “salesman’s stake,” triggering the need for broker-dealer registration.
Cash-strapped states have also taken the approach of aggressively seeking civil and criminal penalties against unlicensed finders. For example, a prominent national law firm acting as a finder was recently required to pay a $550,000 penalty for making introductions and arranging for meetings between a state pension fund’s representatives and one of the firm’s clients seeking investment from the pension funds. Despite the fact that no investment was ever made, the state’s attorney general prosecuted the firm on the grounds that some of the firm’s attorneys were engaging in the marketing of securities without proper licenses. State pension funds and other disgruntled investors are also using rescission rights under securities laws to force the return of money invested in unprofitable funds when unlicensed finders were used to assist with the transactions.
The increased legal prosecution of unlicensed finders means that fewer individuals are willing to provide critical introductions to potential investors. The actions by securities regulators reduce the ability of small businesses to raise capital at a time when capital is in short supply. The development of a “finder’s license,” with requirements that are narrowly tailored to the services that finders provide, might help resolve the issues facing finders and smaller companies, but a narrow license for finders is not the direction that state and federal agencies are currently heading towards.
The Difficulty of Using Broker-Dealers for Small Capital Raises
Instead of using a finder, a company seeking investment may want to try to find a licensed securities broker-dealer. However, there are very few licensed broker-dealers that provide services related to offerings below $5,000,000 in value. The potential risks and relatively modest compensation related to small offerings leaves little incentive for licensed broker-dealers to act as finders for those offerings. Sometimes, however, broker-dealers are willing to assist companies with these smaller raises if they believe that a much larger raise is in the company’s future or that it will increase the likelihood of the broker-dealer being engaged in connection with the sale of the company.
To view a listing of registered broker-dealers, along with each broker-dealer’s history of disputes with customers and regulatory and legal problems, the Financial Industry Regulatory Authority (FINRA) offers on its website the free FINRA BrokerCheck®.
by Matt Storms and Paul Page |