Startup and early-stage companies often want to raise money from investors, and they often need help doing so. That help is often offered from “connectors” or “finders” – friends, friends-of-friends, advisors, etc. – each of who purports to have access to prospective investors, and all of who want to be compensated (i.e., to receive a “success fee”) in the event that their connections end up investing capital. Historically, that has generally been a “no-no.” Federal securities laws generally prohibit compensating anyone who is not a “registered broker-dealer” (which, you can generally assume, people are not) for helping raise money if that compensation is contingent upon the consummation of that capital raise. That may soon change.
On Oct. 7, 2020, the Securities and Exchange Commission (the “SEC”), by a 3-2 vote, proposed a conditional exemption from the broker-dealer registration requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Under the proposal, a company would be able to compensate certain “finders” who assist it with raising capital from “accredited investors” with a success fee that is contingent upon the consummation of the capital raise.
The SEC’s proposal provides that two classes of “finders” – Tier I and Tier II finders – would be exempt from broker-registration requirements and permitted to receive success fees for helping companies raise capital from private markets, as long as certain conditions are met. Specifically:
- Tier I Finders: Tier I finders would only be able to provide contact information of potential investors in connection with only a single capital raise by a single company in any twelve (12)-month period. Tier I finders may not communicate with investors regarding an investment opportunity.
- Tier II Finders: Tier II finders would be allowed to solicit potential investors for an issuing company solely by: (a) identifying, screening and contacting potential investors; (b) distributing offering materials to potential investors; (c) discussing information included in any offering materials, as long as they do not provide advice as to the valuation or advisability of the investment; and (d) arranging or participating in meetings with the issuing company and potential investors.
The proposed exemptions from broker-registration requirements for both Tier I and Tier II finders would be available only if the following conditions are satisfied:
- the capital raise is exempt from registration under the Securities Act of 1933 and the issuing company is not required to file reports under the Exchange Act (i.e., the issuing company need not make “public company” filings);
- the finder does not engage in general solicitation;
- the potential investor is an “accredited investor” or the finder has a reasonable belief that the potential investor is an “accredited investor”;
- the finder and the company enter into a written agreement describing the services to be provided and the compensation to be paid; and
- the finder is not an associated person of a broker-dealer or subject to statutory disqualification under the Exchange Act.
In addition, Tier II finders would be required to make certain disclosures to potential investors prior to solicitation, including disclosure of the finder’s compensation, and to obtain written acknowledgment of those disclosures prior to the time of investment.
Finally, both tiers of finders would not be exempt from the broker-registration requirements if they engage in other activities traditionally reserved to brokers (e.g., helping to structure the capital raise transaction, negotiate terms, handle customer funds, prepare sales materials, perform independent analysis of the sale, engage in due diligence, and/or provide advice about the financial advisability of the investment).
Comments on the SEC’s proposal were due by November 12, 2020. While it is not yet clear how the Biden administration may view the proposal, if the exemption is finalized, looking forward, we expect that more companies seeking to raise small doses of private capital, and finders offering to help them do it, will need help structuring finder-fee agreements in a manner that complies with the final exemption.
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