Raising capital for startups: 3 red flags for not being tricked

Can a startup pay a transaction-based fee for capital raising assistance? This is a very common question. For the most part, the answer is a clear “no,” but why is that? 

The short answer is that—except under certain limited circumstances—it is illegal. Regulatory protections provide investors with the right to their money back with interest and attorney fees, and it may result in, among other things, the founders not only being held personally liable to investors but also getting listed on a  bad-actor list. 

Finding investors is one of the biggest challenges that  companies face. This is especially true for startups because most founders don’t have an established network of investors ready to invest capital. 

Often, founders who are seeking to expand their network of investors will run into someone who would be happy to make a few introductions … for a fee. RUN AWAY!!

Here are 3 Red Flags while raising capital for your company.

Red Flag #1: Transaction-based compensation

Most often, someone who wants a fee for helping to raise capital (often referred to as a “finder”) is not licensed to do so, and generally speaking, use of a finder who is not a licensed broker-dealer is a violation of federal and state securities laws. Below we summarize how to identify a broker-dealer and then look at the potential negative consequences of using an unlicensed broker-dealer.

What is an unlicensed broker-dealer?

The answer is simple: Just ask the finder, “Are you a registered FINRA Broker-Dealer?” The answer is either yes or no.

For decades, the SEC & FINRA have defined a four-factor test to determine when a “finder” is required to register as a broker-dealer. The SEC’s position is that these 4 factors will be analyzed in determining when someone is acting as a broker-dealer, with no one factor being dispositive:

  1. Whether the person receives commissions or other transaction-based compensation;
  2. Whether the person makes buy/sell recommendations and provides investment details;
  3. Whether the person has a history of selling securities (regular activity); and
  4. Whether the person takes an active role in negotiations between the investor and the issuer.

“What if a finder receives a percentage of the money raised through finder introductions, but does not make recommendations, does not have a history of selling securities, and does not take an active role in negotiations between the investor and the issuer?” 

Despite its emphasis on four factors, the SEC has stated in several no-action letters that transaction-based compensation represents a hallmark of being a broker-dealer, even when the other three factors are absent. Consequently, an individual or company that receives a commission substantially increases the risk that the party receiving the commission will be considered a broker-dealer. For decades, the best advice has been that in view of the risks involved, issuers should typically not engage finders on a percentage-based compensation basis.

Red Flag #2: Reliance on No-Action Letters

On several occasions, we have come across finders who refer to a no-action letter issued by the SEC in 2014 as evidence they can receive a commission despite not being a licensed broker-dealer.

The problem with that position is that the letter has several conditions, including that the buyer of the securities being sold has, following the sale of the securities, (i) control of the company, and (ii) must actively operate the company.

Nearly all startup financings do not fit into this scenario, so the no-action letter does not apply.2

Finders will also often attempt to find (and share with the startup’s leaders) comfort by relying on the 1991 SEC No-Action Letter involving the singer Paul Anka. While often cited by finders, the SEC staff’s decision to not recommend enforcement against Mr. Anka—if, without registering as a broker-dealer, he provided the company a list of potential investors in exchange for a commission—is of limited relevance and utility.

The SEC staff noted its no-action decision was conditioned on several factors, including that Mr. Anka was not engaging in the following activities: soliciting the prospective investors, participating in any general solicitation, assisting in the preparation of sales materials, performing independent analysis, engaging in “due diligence,” assisting or providing financing, providing valuation or investment advice, and handling any funds or securities.

Red Flag #3: Liability for using an unlicensed broker-dealer in capital raise

What Possible Liability Is There for Using an Unlicensed Broker-Dealer to Raise Capital? 

Using a finder will create liability under federal and state law. Agreements for the sale of securities made in violation of federal securities law may be held void.4 This would certainly apply to the agreement with the unregistered broker who attempts to collect a fee for assisting in the sale of the securities.

While the startup may feel that this is not such a bad thing, a violation of federal securities laws also will void (or make voidable) the agreement between the startup and investors under which the startup raised the funds. If the agreements are held void by a court, then all parties to those agreements would have a right of rescission that would last for the later of three years from the transaction or one year from the date the violation is discovered.

A right of rescission is simply a right to cancel the agreement and return each party to its original position, which means returning investments back to investors. In other words, the use of a finder who is not but should be a registered broker-dealer in effect gives the investors a multi-year redemption right.

Are There Other Potential Consequences of Engaging an Unlicensed Broker-Dealer to Raise Capital?
Yes, otherwise we would not have posed the question. Founders who engage unregistered broker-dealers to raise capital may:

  1. SEC Enforcement Actions: Face enforcement actions from the SEC as an aider and abettor8;
  2. State Regulatory Actions: Face enforcement actions from state securities regulators; and
  3. Prohibition and Labeling: Be labeled a “bad actor” and prohibited from participating in or being involved with companies that do securities offerings made under commonly used securities exemptions.9

Additionally, the startup and its principles may be prohibited from using the updated JOBS Act regulations such as Rule 506, Regulation CF, and Regulation A+ securities offering, which is the most commonly relied-upon securities exemption for startups and emerging growth companies. And, just because the list goes on, the use of an unlicensed broker-dealer could impact the ability to close future rounds of financing because of the contingent liability associated with the initial violation, which is likely to come up in investor due diligence.

Online Capital Formation for Private Companies

In the fast-paced private company landscape, understanding Online Capital Formation dynamics is not just a strategic advantage – it’s imperative. As we commemorate the twelfth anniversary of the JOBS Act in 2024, it’s evident that evolving capital-raising regulations have paved the way for a transformative approach to business financing. In this ever-changing scenario, everyone in the private market needs to grasp the significance of Online Capital Formation to unlock myriad opportunities for their ventures.

Table of Contents

  1. Making Capital Formation Accessible for Private Enterprises
  2. The Complexity of RegCF and RegA+
  3. Beyond Conventional Crowdfunding
  4. Seizing the Future with Online Capital Formation
  5. Final Insights

 

Making Capital Formation Accessible for Private Enterprises

At its core, the democratization of capital is a driving force behind Online Capital Formation. Gone are the days when crowdfunding merely conjured images of Kickstarter campaigns. Today, it has evolved into a sophisticated financial tool, especially with the maturation of Regulation CF (RegCF) and Regulation A+ (RegA+) over the past decade.

RegCF and RegA+ are two sets of rules established by the U.S. Securities and Exchange Commission (SEC) to govern equity crowdfunding. They were both introduced as part of the JOBS Act (Jumpstart Our Business Startups Act) and their primary goal is to make it easier for businesses and startups (from small to enterprises) to raise capital by offering and selling securities online.

The concept of digital securities involves representing traditional financial instruments (such as stocks or bonds) in digital form using blockchain technology. Digital securities enable more efficient and transparent transactions, and they can be traded on digital securities exchanges.

The Complexity of RegCF and RegA+

RegCF and RegA+ transcend the traditional crowdfunding model, where entrepreneurs pitch ideas for product launches. Instead, they empower companies to transform investors into shareholders. The focus has shifted from merely selling stories to selling stock – a nuanced shift that goes beyond the conventional understanding of crowdfunding.

In order to fit in each of these regulations, companies must pass the eligibility criteria for each of them and provide certain disclosures to investors, including information about their business, financial condition, and the terms of the offering. The level of disclosure required is less extensive compared to traditional IPOs, but it aims to provide investors with enough information to make informed investment decisions.

Beyond Conventional Crowdfunding

These regulations are more than regulatory frameworks; they’re a paradigm shift that offers private companies a more expansive and flexible avenue for raising capital. They allow them to raise capital from both accredited and non-accredited investors, which includes their own clients and employees. RegCF allows them to raise up to 5 million dollars while with RegA+, it’s possible to raise up to 75 million dollars.

Equity Crowdfunding is an alternative pathway to access capital markets, offering a more cost-effective and less burdensome option than a full IPO. It has helped more people invest in early-stage funding, making investment opportunities available to a wider range of investors. With these regulations, you can leverage the internet and technology to connect with more investors and grow the business.

Seizing the Future with Online Capital Formation

While the term “crowdfunding” remains rooted in popular imagination, it falls short of encapsulating the depth and complexity of RegCF and RegA+. We must recognize these exemptions have matured into a robust mechanism that demands a more nuanced understanding. They must carefully navigate the regulatory requirements and considerations as this is monitored by the SEC aiming to ensure investor protection and maintain market integrity.

To shed light on this evolution, we have collaborated with industry experts, including Sara Hanks, CEO/Founder of CrowdCheck, and Douglas Ruark, President of Regulation D Resources, now known as Red Rock Securities Law. Together, we aim to redefine the landscape by emphasizing what we believe heralds a new era in crowdfunding: Online Capital Formation

Additionally, success in equity crowdfunding often depends on effective marketing, transparent communication, and a compelling value proposition for investors.  From accessing diverse investors to increasing brand visibility, this overview highlights seven key benefits. Take a look at the chart.

# Top 7 Benefits of Democratizing Capital Formation
1 Access to Diverse Investors
2 Engagement of Customers
3 Increased Brand Visibility
4 Flexibility in Fundraising
5 Gathering Early Feedback
6 Cost-Effectiveness
7 Potential for Liquidity

A Closer Look at the Top 7 Benefits of Democratizing Capital Formation

Final insights

As private company owners and managers, the onus is on you to comprehend the evolving dynamics of Online Capital Formation. It’s not merely a trend. Embrace the opportunities, stay informed, and position your venture at the forefront of this new era in crowdfunding. The journey begins with understanding. If you’re looking to raise capital and want to know more about your company’s suitability and which steps to take first, book a call with one of our specialists.

Online Capital Formation And Why You Have To Understand It

The JOBS Act reached its tenth anniversary in 2022. We celebrated the date with the launch of our Podcast, KoreTalkX, recently mentioned by Spotify as in the top 10% of the most shared shows globally. But the regulations that brought a lot of novelties to the capital raising process still face some misconceptions. Especially regarding Crowdfunding. We are introducing Online Capital Formation and why you have to understand it.

We do write a lot about the democratization of capital because we believe that everyone should be able to participate and share in the benefits. Whether as entrepreneurs, brand advocates, innovators, or investors (both accredited and non-accredited). What we may be missing here is that Regulation CF (RegCF) has matured over the past decade, and it is time to look at it in a more complex way.

Crowdfunding?

For many individuals, the word  “crowdfunding” still evokes Kickstarter as a Top of Mind idea. Entrepreneurs that need money to launch a product pitch their ideas online. People can contribute based on a variety of rewards listed on a website. But that is far from being a regulated entity.

RegCF helps companies turn investors into shareholders. Companies and product makers are not selling their stories anymore. They are selling their stock. And that is why we feel the word “crowdfunding” doesn’t encompass the whole idea behind it.

That is why we put together our KorePartners, like Sara Hanks (CEO/Founder of CrowdCheck) and Douglas Ruark (President of Regulation D Resources) to help us put a flag in the ground to what we believe is the new era in Crowdfunding: Online Capital Formation.

Sara Hanks, Douglas Ruark. and Oscar A Jofre, our CEO and co-founder, will join our communications coordinator Rafael Gonçalves in a webinar next Monday, on December, 19th, at 4 PM EST, to remind us all of the paths we have traveled while pointing the way forward for the Online Capital Formation idea.

Join us on LinkedIn Live or subscribe on Airmeet.