The Problem with Finders

tl;dr – When companies have issues raising capital they engage finders.  However, using a finder opens you up to substantial legal and reputational risk for a high cost.  If you do hire a finder make sure they a registered broker-dealer if they are taking a percentage of the raise.  If they are not a registered broker-dealer then minimize their work to introductions and pay them a flat fee and perhaps grant non-success based equity.

Recently, a few clients asked me for my thoughts on using a “finder” to help them raise capital.   The clients were early into their fundraising process so in no short terms I said that would be a terrible idea. 

This post dives deeper into my position on the matter from both a legal as well as market perspective.  Also, given that the SEC has proposed rules to expand the pool of finders I expect there to be wave of finders looking to sell their services to startups shortly. 

Legal Issues – Potential SEC Violations and Penalties 

“Are they a registered Broker-Dealer?” is the first question I ask clients when they want to engage a finder.

Under the Securities Exchange Act of 1934 and state securities laws, a “broker-dealer” is “any person engaged in the business of effecting transactions for the account of others.” It is unlawful for any broker-dealer to “effect any transaction in, or induce or attempt to induce the purchase or sale of, any security” without first registering as a broker-dealer with the Securities and Exchange Commission (SEC) and applicable state regulators. 

So why does this matter?  If your finder engages in broker-dealer activities (which is what they claim to do) and they are not a registered broker-dealer then the following negative consequences can occur for the company.

  • Regulatory sanctions for employing an unregistered broker or for aiding and abetting the violation of federal/state law by the unregistered broker, including administrative fines, inability to rely on certain securities registration exemptions, and criminal penalties.
  • 10b-5 securities fraud liability to investors and regulators for failure to disclose use of an unregistered broker.
  •  Rescission claims by investors demanding return of invested funds plus statutory interest and attorneys’ fees.
  •  Loss of the securities registration exemption. 
  • Responsibility for the unregistered broker’s actions such as general solicitation (prohibited by Regulation D), and fraudulent misrepresentations by the broker.
  • Unavailability of legal opinions on legality of the issuer’s stock.
  • Loss of institutional investors’ interest in the offering.
  • Tainted financial statements (disclosure of contingent liabilities to investors and regulators).

These are some devastating consequences for any company but especially for a startup.  What typically triggers a “broker-dealer” alarm is whether the finder is facilitating a securities transaction and is being paid a portion of the proceeds (i.e., finder gets x% of  y raise).

Thankfully for finders the rules are in the process of changing to be more lenient and we will analyze those rules once finalized by the SEC. 

Business Issues – Negative Signals & Cost Paid for Value Added

Fairly or not, nothing screams adverse selection more than a startup that is paying a broker to find capital.  Traditionally, founders pitch their companies to angels, VCs, and others familiar to the startup ecosystem.  Normally, if a startup is unable to raise via those paths then it may seek non-traditional funding and/or employ a finder.  Therefore, an assumption is that only the unsuccessful startups who cannot raise via the traditional route employ finders.  Essentially the view is no one else wants to invest so the startup is desperate.

Next, I have seen engagement letters from finders that ask for 10% of the current raise (whether they took a substantive part in closing the money) and a monthly consulting fee of $10,000.  Here is a scenario –  you are raising $1million for seed fundraising.  You engage a finder early on with the terms above and you accept because you are eager to close.  The whole raise takes about 5 months (not uncommon).  The finder would be entitled in this scenario to $150,000 or 15% of the raise.

And that only considers that you can raise the full amount.  Investors may be put off by the fact that their capital is going to a finder and not to the operations of the startup.  Investment documents typically contain representations whereby the startup must disclose that a portion of the proceeds will go to a finder.  Assuming it takes you 5 months to raise only $500K then $100K or 20% of the proceeds will go to the finder.

Finally, the level and amount of work done by finders vary.  Some finders do not have a track record or perhaps typically do real estate deals – just like any service provider their experience and expertise should match your startup’s needs.  Certain finders will only offer some contact information or forward along your deck (which makes them less like a “broker-dealer”) while other finders will work on your pitch deck, review your financials, and even try to negotiate terms on behalf of the company with potential investors.  In short, your mileage may vary with finders as there is no set standard.

If you need to use a Finder– How to do it.

If you are struggling at raising capital and absolutely need financing, then finders are OK as a last resort.  You understand the underlying risks and costs (after talking to a lawyer) but determine it is still in the best interest of the company to use one.  Here are your next steps

  • Review your finder’s background and work with startups.  Ask for referrals.
  • Determine if the finder is a registered broker-dealer.  
    • If yes, then they can take a percentage of the deal and you should push them to do as much work as possible to get true value.
    • If no, the pay a flat small fee and perhaps grant them equity with time-based (i.e., not success based) vesting and limit their work to introductions to investors
  • Work with your attorney to negotiate terms as they will understand market and watch out for gotchas (i.e., we take a percentage even if we do not make the introduction)
  • Stay on top of your finder to help close the round and disclose the fees to investors if the deal is structured as a broker deal

Raising money is hard for most startups and using a finder can seem like a good solution to free up your time and close deals.  However, there are great costs and risks with this approach and a founder should be their own finder.  It is part of the hustle and grind that comes with running a startup.

Tags: , , Last Updated: April 9th, 2021

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