The Legal Risks of Paying Finder's Fees: What Startups Need to Know

Introduction

In the world of startups, raising capital is a critical and often daunting task. Entrepreneurs must seek out investors who share their vision and are willing to provide the necessary funds to bring their ideas to life. One approach that has gained popularity is the use of finders, individuals or entities that help startups connect with potential investors for a fee. While finders can undoubtedly be an asset, it is essential for startups to understand the legal implications of their involvement and the fees they charge. In this blog, we will explore the complexities surrounding finder’s fees, the potential consequences of noncompliance with U.S. securities laws, and best practices for avoiding these pitfalls.

U.S. Securities Laws and the Unregistered Broker-Dealer Risk

Under Section 15(a) of the Securities Exchange Act of 1934, it is unlawful for any broker or dealer to induce or attempt to induce the purchase or sale of any security unless they are registered as a broker-dealer. Charging a success fee tied directly to the closing of an investment round may be viewed as acting as an unregistered broker-dealer, which is prohibited.

Two relevant SEC No-Action Letters, the Brumberg, Mackey & Wall, PLC no-action letter (2010), and the Paul Anka no-action letter (1991), emphasize that receiving transaction-based compensation may be viewed as acting as an unregistered broker-dealer. Penalties for acting as an unregistered broker-dealer may include fines and the potential rescission of completed transactions, in which investors could seek a return of their investment.

Structuring Fees to Minimize Risks

To minimize the risk of being considered an unregistered broker-dealer, startups can structure fees based on a flat fee, hourly rate, or a success fee tied to a milestone that precedes the actual investment, such as due diligence initiation. However, charging a success fee tied to due diligence initiation may still carry some risk.

Registering as a Broker-Dealer

The costs of registering as a broker-dealer with the Financial Industry Regulatory Authority (FINRA) and the SEC can be significant. The FINRA New Member Application (NMA) fee ranges from $8,000 to $50,000, depending on the size and nature of the new member applicant’s business. State registration fees also vary and may be required for each state in which the broker-dealer intends to conduct business.

Permitted Services in a Fundraising Consultant Agreement

A sample list of permitted services in a Fundraising Consultant Agreement may include assistance in creating and refining pitch materials, researching and identifying potential investors, reaching out to potential investors to introduce the client’s business, arranging and preparing client meetings with potential investors, offering ongoing general advice and guidance for the fundraising process, periodic progress updates, conducting market research and analysis, assisting with the preparation of investor due diligence materials, and providing input on the development of the client’s business plan and financial model.

Here’s how it can look inserted a Fundraising Consultant Agreement:

1. Services. Consultant agrees to provide the following services to Client (the “Services”):
a. Assistance in creating and refining pitch materials, including but not limited to pitch decks, executive summaries, financial projections, and investor presentations;
b. Researching and identifying potential investors that may be a good fit for the Client’s business, industry, and funding needs;
c. Reaching out to potential investors via email, phone, or other appropriate means to introduce the Client’s business and gauge their interest;
d. Arranging, scheduling, and preparing Client for meetings with potential investors, including providing background information on the investors and their investment preferences;
e. Offering ongoing general advice, guidance, and best practices for the fundraising process, including reviewing and providing feedback on Client’s investor communications;
f. Periodic progress updates and consultation calls to discuss the status of the fundraising efforts and potential next steps;
g. Conducting market research and analysis related to the Client’s industry, competitors, and target market;
h. Assisting with the preparation of investor due diligence materials;
i. Providing input on the development of the Client’s business plan and financial model.

2. Compensation. In consideration for the Services provided by Consultant, Client agrees to pay Consultant as follows:
a. A non-refundable retainer fee of $[Amount] upon execution of this Agreement;
b. A fixed fee of $[Amount] for each investor meeting arranged by Consultant. This fee shall be payable within [Number of Days] days after the meeting takes place.
c. Hourly fee…

Mitigating the Risk of Violating U.S. Securities Laws

To further mitigate the risk of violating U.S. securities laws, startups should consider the following:

1. Avoid charging success fees tied to capital raised or due diligence completion, as this reduces the likelihood of being considered transaction-based compensation.
2. Clearly define the scope of services in the consulting agreement, emphasizing advisory and support services rather than broker or facilitation roles.
3. Do not negotiate investment terms on behalf of the startups, which could be seen as broker-dealer activity.
4. Limit involvement in the fundraising process to providing guidance, preparing materials, and making introductions.
5. Refrain from directly participating in the solicitation of investors or the closing of any transactions.
6. Maintain accurate records of the services provided and the fees charged, to demonstrate that fees are for consulting and advisory services rather than facilitating securities transactions.
7. Ensure that any marketing materials, pitch decks, or other documents created on behalf of the startups clearly indicate that the finder is acting as an advisor or consultant and not as a broker-dealer.

Conclusion

The use of finders and the payment of finder’s fees can be a valuable resource for startups seeking capital. However, navigating the complex web of U.S. securities laws and avoiding potential violations requires careful consideration and planning. By structuring fee arrangements to minimize the risk of being considered an unregistered broker-dealer, defining the scope of services in a consulting agreement, and adhering to best practices that emphasize the advisory role of the finder, startups can greatly reduce the likelihood of running afoul of securities regulations.

In summary, while finders can be instrumental in connecting startups with potential investors, it is crucial for startups to be aware of the legal implications surrounding finder’s fees and the potential consequences of noncompliance with U.S. securities laws. By taking the necessary precautions and following best practices, startups can effectively leverage the expertise of finders while minimizing the risks associated with their involvement.

FAQ

Q: What is a finder’s fee?

A: A finder’s fee is a fee paid to an individual or entity that introduces a startup to potential investors. Finders are usually individuals or firms that have a network of contacts in the investment community and can connect startups with investors. The fee is typically a percentage of the total investment raised, and it can vary depending on the size of the investment and the level of involvement of the finder.

Q: What is an unregistered broker-dealer?

A: An unregistered broker-dealer is an individual or firm that engages in the business of effecting securities transactions for the accounts of others without being registered with the SEC and/or FINRA. The term “effecting securities transactions” refers to the act of soliciting or selling securities, or participating in the negotiation of securities transactions. Under the Securities Exchange Act of 1934, it is illegal for an unregistered broker-dealer to engage in such activities.

Q: What are the penalties for acting as an unregistered broker-dealer?

A: The penalties for acting as an unregistered broker-dealer can be severe. In addition to potential fines and the rescission of completed transactions, individuals and firms can face civil and criminal charges, and even imprisonment in some cases. Moreover, the SEC can pursue administrative sanctions, such as revoking the registration of a broker-dealer or prohibiting individuals from serving as officers or directors of public companies.

Q: How can startups structure finder’s fees to minimize the risk of being considered an unregistered broker-dealer?

A: To minimize the risk of being considered an unregistered broker-dealer, startups can structure finder’s fees based on a flat fee, hourly rate, or a success fee tied to a milestone that precedes the actual investment, such as due diligence initiation. However, it is important to note that charging a success fee tied to due diligence initiation may still carry some risk. Therefore, startups should consult with legal counsel to ensure that their fee structure is compliant with securities regulations.

Q: What services are typically included in a Fundraising Consultant Agreement?

A: A Fundraising Consultant Agreement outlines the scope of services that a finder will provide to a startup. Services that may be included in the agreement include assistance in creating and refining pitch materials, researching and identifying potential investors, reaching out to potential investors to introduce the client’s business, arranging and preparing client meetings with potential investors, offering ongoing general advice and guidance for the fundraising process, periodic progress updates, conducting market research and analysis, assisting with the preparation of investor due diligence materials, and providing input on the development of the client’s business plan and financial model.

Q: What are some best practices for minimizing the risk of violating U.S. securities laws when using finders?

A: Best practices for minimizing the risk of violating U.S. securities laws when using finders include avoiding charging success fees tied to capital raised or due diligence completion, clearly defining the scope of services in the consulting agreement, refraining from negotiating investment terms on behalf of the startups, limiting involvement in the fundraising process to providing guidance and support, maintaining accurate records of services provided and fees charged, and ensuring that marketing materials and pitch decks indicate that the finder is acting as an advisor or consultant and not as a broker-dealer. Startups should also consult with legal counsel to ensure that their arrangements with finders are compliant with securities regulations.

Q: What is due diligence, and how is it related to finder’s fees?

A: Due diligence is a process of investigating and evaluating a potential investment opportunity before making a final decision. The due diligence process may include a review of financial statements, legal documents, and other relevant information to determine the risks and potential returns of the investment. The payment of finder’s fees tied to due diligence initiation may be viewed as acting as an unregistered broker-dealer, which is prohibited under securities regulations. Therefore, startups should be cautious when structuring finder’s fees to avoid any potential violation of securities laws.

Q: Can a startup use a finder to raise capital without paying a finder’s fee?

A: Yes, a startup can use a finder to raise capital without paying a finder’s fee. However, finders are typically compensated for their services, and many have established networks of investors that can be beneficial to startups. Moreover, finders may offer valuable guidance and support during the fundraising process, which can be instrumental in securing funding. Therefore, startups should carefully evaluate the benefits and risks of working with a finder before deciding whether to pay a fee for their services.

Q: What is FINRA, and how does it regulate broker-dealers?

A: FINRA, the Financial Industry Regulatory Authority, is a non-governmental organization that regulates broker-dealers in the United States. FINRA oversees the registration and conduct of broker-dealers and ensures compliance with federal securities laws. FINRA also enforces its own rules and regulations, including rules related to the registration of broker-dealers and the payment of compensation to finders. Broker-dealers must register with FINRA before engaging in securities transactions and must comply with FINRA’s rules and regulations to maintain their registration.

Q: What are the benefits of working with a finder, and how can startups ensure a successful partnership?

A: Working with a finder can offer several benefits to startups, including access to a network of investors, valuable guidance and support during the fundraising process, and assistance in creating and refining pitch materials. To ensure a successful partnership with a finder, startups should carefully evaluate potential candidates and select a finder with a proven track record of success. Startups should also clearly define the scope of services in the consulting agreement and maintain open communication throughout the fundraising process. Finally, startups should be prepared to provide the finder with the information and resources necessary to effectively connect with potential investors and secure funding.

Q: Can a startup work with multiple finders simultaneously?

A: Yes, a startup can work with multiple finders simultaneously. However, startups should ensure that all finders are aware of each other’s involvement and that there is no overlap or conflict of interest. Moreover, startups should ensure that each finder’s fee structure is clearly defined and that the total compensation paid to all finders is reasonable and does not exceed industry standards.

Q: What are the potential risks of working with a finder, and how can startups mitigate these risks?

A: The potential risks of working with a finder include the risk of violating securities laws, the risk of paying excessive fees, and the risk of working with an unscrupulous or unqualified finder. To mitigate these risks, startups should carefully evaluate potential candidates and select a finder with a proven track record of success. Startups should also ensure that the fee structure is reasonable and compliant with securities regulations, and that the finder’s involvement is limited to advisory and support services. Finally, startups should maintain open communication with the finder and be prepared to terminate the relationship if necessary.

Q: What should startups consider when negotiating the fee structure with a finder?

A: When negotiating the fee structure with a finder, startups should consider the level of involvement required, the size and complexity of the investment, and the industry standard for finder’s fees. Startups should also consider the potential risks of charging success fees tied to capital raised or due diligence completion, and may consider structuring fees based on a flat fee or hourly rate. Finally, startups should consult with legal counsel to ensure that the fee structure is compliant with securities regulations.

Q: How can startups ensure that the finder is acting in their best interests and not engaging in any unethical behavior?

A: To ensure that the finder is acting in their best interests and not engaging in any unethical behavior, startups should carefully evaluate potential candidates and select a finder with a proven track record of success. Startups should also clearly define the scope of services in the consulting agreement, maintain open communication with the finder, and be prepared to terminate the relationship if necessary. Startups should also monitor the finder’s activities and ensure that they are complying with securities regulations and acting in accordance with the terms of the consulting agreement.

Q: How can startups find qualified and reputable finders to work with?

A: Startups can find qualified and reputable finders through networking, referrals, and online platforms. Networking can involve attending industry events and conferences, reaching out to other startups or investors, and joining relevant online communities. Referrals can come from other startups, investors, or legal and financial advisors. Online platforms such as AngelList, Gust, and SeedInvest can also connect startups with potential finders. Regardless of the method, startups should carefully evaluate potential candidates and conduct due diligence to ensure that the finder is reputable and qualified.

Q: What are the potential benefits of registering as a broker-dealer with FINRA and the SEC?

A: Registering as a broker-dealer with FINRA and the SEC can offer several benefits, including increased credibility with investors, the ability to negotiate investment terms on behalf of startups, and the ability to earn transaction-based compensation. However, the costs associated with registering as a broker-dealer can be significant, and the regulatory requirements can be complex and time-consuming. Therefore, startups should carefully evaluate the costs and benefits before deciding whether to register as a broker-dealer.

Q: How can startups ensure compliance with securities regulations when working with finders?

A: To ensure compliance with securities regulations when working with finders, startups should consult with legal counsel, carefully evaluate potential candidates, and clearly define the scope of services in the consulting agreement. Startups should also avoid charging success fees tied to capital raised or due diligence completion, refrain from negotiating investment terms on behalf of the startups, and limit involvement in the fundraising process to providing guidance and support. Finally, startups should maintain accurate records of services provided and fees charged, and ensure that marketing materials and pitch decks indicate that the finder is acting as an advisor or consultant and not as a broker-dealer.