Unregistered Broker-Dealers: The Risks of Hiring Someone to Help Raise Startup Funds
Raising money for your startup is often a long, arduous, and emotionally draining process. For many founders, fundraising can become a full-time job. Adding this on top of your efforts to run and grow a business is no small task.Occasionally, someone may approach you and offer to facilitate connections to their investor connections looking to contribute money to a company just like yours. This person may be an existing connection, or they may connect with you out of the blue. They may also offer to help negotiate fundraising terms and bring your financing to a quick and successful close. These individuals will generally ask for some form of compensation–often a portion of the funds they help your company secure.This relationship, while enticing, comes with risks–even if you trust the person you’re engaging. Someone who assists companies in fundraising can be considered a “broker-dealer” by the Securities and Exchange Commission (SEC), and engaging an unregistered broker-dealer is a risky proposition that companies should be wary of.
What is a Broker-Dealer?
A “broker-dealer” is a person who is "engaged in the business of effecting transactions in securities for the account of others” according to the Securities Exchange Act of 1934. Generally, any broker-dealer that raises (or attempts to raise) money on behalf of your company in exchange for compensation must register with the SEC, the Financial Industry Regulatory Authority (FINRA), and (potentially) the states where they operate. The SEC considers four factors when determining whether or not someone must register as a broker-dealer, with no one factor being dispositive:
- Whether the person receives commissions or other transaction-based compensation;
- Whether the person makes buy/sell recommendations and provides investment details;
- Whether the person has a history of selling securities (regular activity); and
- Whether the person takes an active role in negotiations between the investor and the issuer.
The SEC has stated in several no-action letters that transaction-based compensation almost always triggers a broker-dealer classification, even absent the other three factors. Consequently, someone who receives (or will receive) compensation tied to the success of your financing round will almost always be considered a broker-dealer. As a rule, startups should typically not engage finders on a percentage-based compensation basis unless that finder is a registered broker-dealer. This includes cash compensation or equity grants with a vesting schedule tied to the success of a financing.
What Are the Risks?
If your company raises money using an unregistered broker-dealer, there can be significant negative implications. Your investors may be able to force your company to buy back their investment at the price they originally paid for it. (This functions like a “put option”, meaning the investors can exercise their buy back right at any time in their discretion.) If your company continues to grow and increase its value, the investors may never raise issues with the unregistered broker or demand your company return the investors’ original investments. But if the company’s value decreases, investors looking for the exits can leverage the company’s use of an unregistered broker-dealer to force it to buy back their investment at the price they initially paid. They might even be able to force the company’s founders or executives to buy them out, since the founders and/or executives violated securities laws in effecting the financing.Additionally, a company that uses an unregistered broker-dealer may face civil and criminal penalties, and the broker-dealer may be subject to SEC sanctions and/or criminal prosecution under both federal and state law. If the broker-dealer is deemed to be a “bad actor” under federal law, the company will lose its ability to rely on certain exemptions to securities laws, inhibiting the company’s ability to raise future financing rounds.Finally, even if no current investor takes issue with the use of an unregistered broker-dealer, future investors may notice the violation and either forego investment entirely or demand financing terms that safeguard them against risks of future issues related to the unregistered broker-dealer.
What Should Startups Do?
Before engaging anyone to assist your fundraising efforts, talk to your attorney about your specific situation to see how it falls within SEC guidelines. Additionally, consider whether you actually need to engage a third-party to help you raise your round. Fundraising is hard, but, in the long term and big picture, cutting corners by engaging outside help may not be worth the fee (whether cash, equity, or both) versus the amount of money they raise. Using a finder or broker-dealer can also negatively affect your company’s reputation because many investors are hesitant to invest in companies using finders to help with their fundraising efforts.Nevertheless, some companies find that using a finder can be helpful, and the use of investment bankers or other registered broker-dealers is fairly common in later stage financings, where companies are looking to raise significant amounts of capital. Confirm that anyone acting as a finder or broker-dealer is registered with the SEC, FINRA, and any applicable states. FINRA provides a searchable database, called BrokerCheck, you can use to research a broker’s information and registration status. If a finder is not registered, it’s generally not a good idea to engage them.Headquartered in the Research Triangle region of North Carolina, Fourscore Business Law serves entrepreneurs and businesses in the Triangle, throughout the Southeast and in Silicon Valley / San Francisco. We also represent venture capital funds and other investors who invest in companies throughout the U.S. The idea of delivering maximum impact in a simple and succinct manner is what we’re calling the Fourscore Principle. And that is what Fourscore Business Law is based on. Our clients operate in a broad range of industries including tech, IoT, consumer products, B2B services and more. Questions? Shoot us an email or give us a call at (919) 307-5356. Your first call is on us.