One of the requirements in a private offering is that the issuer have a “pre-existing substantive relationship” with its investor. Once exhausting contacts with local or regional venture capital firms and angel investor groups, relatively few entrepreneurs seeking equity investments have adequate personal contacts with wealthy people who can provide sufficient money to meet the capital needs of the entrepreneur’s business. For those who don’t, one option is to engage an intermediary or “placement agent” to assist them in the process of finding potential investors. If a placement agent of an issuer has a pre-existing substantive relationship with an investor, that relationship generally extends to the issuer for purposes of avoiding the advertising restriction imposed on companies in private offerings. A placement agent usually refers to a person or firm that is a registered broker-dealer, but sometimes also includes “finders.”
Broker-Dealers vs. Finders
Broker-dealers are regulated professionals or firms that have passed a series of exams and have gone through a lengthy registration process that includes interviews. Finders, on the other hand, are not generally regulated. According to federal law, a broker-dealer is “any person engaged in the business of effecting transactions in securities for the account of others.”
For purposes of this article, the key language is “in the business of effecting transactions.” A finder is someone not in “the business of effecting transactions.” Rather, finders infrequently bring investors and companies together, but that’s all they can do. By law, a finder is not permitted to pitch for the company, develop deal terms, or negotiate for or represent the investor or the company.
There are likely many finders out there who actually perform the services of a broker-dealer, but have failed to register as one because of either ignorance or the time and cost that it takes to become registered. However, it is a violation of federal and most state securities laws to fail to register if a person or firm is engaging in conduct that constitutes broker-dealer activities. A violation of one of those laws can bring fines, investment rescission, penalties, headaches, and in egregious situations, imprisonment.
Some states place significant restrictions on performing any “finder-related” activities, and take away common blue sky transaction exemptions if an issuer compensates a finder as part of a sale of securities to the particular state’s residents. Moreover, there are regulatory issues of giving transaction-based compensation to finders (e.g., an 8% finder’s fee), which often times is exactly what the company and finder want to do.
Because of these and other regulatory issues and various limitations associated with using finders, it is usually better to work with a broker-dealer rather than a finder. However, there are many more finders that are willing to work with early-stage companies than there are broker-dealers willing to do so.
Selecting a Placement Agent
You may ask, “how does one find a placement agent?” Entrepreneurs can talk with their lawyers, accountants, or other entrepreneurs about their experiences with various placement agents in their area. Generally speaking, for smaller transactions (e.g., under $5 million), placement agents will typically operate on a regional basis (rather than national).
When selecting a placement agent, there are many things to consider. Probably the most important consideration is trust. By using a placement agent, you are putting a lot of faith in an individual or firm. The reverse is true as well from the placement agent’s perspective in that their reputation is affected by the companies with which they work. Below are some other considerations:
- Experience generally as a placement agent
- Experience and success with companies in similar industries raising comparable amounts of money.
- Knowledge and experience with securities laws
- For broker-dealers, good written policies and procedures
- For finders, the impact of using a finder on state Blue Sky exemptions, and potential legal issues with using the particular finder
- Pre-existing substantive relationships with prospective accredited investors
Contracts with placement agents vary significantly. At the extremes, I have seen handshake deals, which I strongly advise against, and I have seen 25-page agreements. Below is a list of areas that are commonly negotiated in arrangements with placement agents:
- Compensation amount and type (e.g., retainer/monthly fee versus a transaction-based fee)
- Events that give rise to compensation
- Ability to terminate and effect of termination
- The duration of the “tail” post-termination
- Additional services
- Representations, warranties, and covenants
- Use of affiliates to assist in process
Once a company decides to engage a placement agent, finding the right one(s) under the right terms are essential. The placement agent may not only affect the success of your offering, but the placement agent may also affect (positively or negatively) the reputation of you and your company, expose you to securities law liability and sanctions, and bind you to a long-term, comprehensive, and expensive set of services.
So, if you decide to work with one or more placement agents, choose carefully.