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.

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