Founders, Finders and Financings: Beware the Unregistered Broker-Dealer
Raising money is hard. Many founders think that it’ll be easy, and that a dozen investors will be lining up outside the room after their first pitch with term sheets in hand. That’s how it goes in the movies. Few understand that fundraising is often a slog that takes much more time and energy and attention than they imagined. And this is why it’s tempting, when someone tells you they’ve got a rolodex and investor connections, and can help you put together your Series A in exchange for a small percentage of the financing, to take them up on their offer. Is this a good idea?
A registered broker-dealer can be an asset to an early-stage company trying to raise money, but using an unregistered broker-dealer is a risky proposition that companies should be wary of.
What is a Broker-Dealer?
Let’s start by breaking down what a broker-dealer is. Anyone that raises (or attempts to raise) money on behalf of your company in exchange for some form of compensation must be a broker-dealer registered with the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and perhaps even the states where they operate. The general rule is that anyone who “effects transactions in securities or attempts to induce the purchase or sale of securities” must be registered.
The question, then, is whether the person you have in mind would be acting as a broker-dealer. There are four factors: (1) do they negotiate the sale of securities? (2) do they recommend or discuss securities with potential investors? (3) do they receive transaction-based compensation? (4) have they been involved in effecting securities transactions in the past?
What Are the Risks?
If your company raises money from investors through an unregistered broker-dealer, the investors probably have a rescission right, which allows the investors to force your company to buy back their investment at the price they originally paid for it. This functions like a put option that can be used at the investors’ discretion. If your business is doing well and increasing in value it’s possible that your investors will not raise any issues with using an unregistered broker. But if the company starts underperforming, or even just hits a bump in the road – when you are least able to deal with it – 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.
And these might not be the least of your issues. A company that uses an unregistered broker-dealer could face civil and criminal penalties, and the finder herself could be subject to SEC sanctions or criminal prosecution under both federal and state law. If the finder is a “bad actor” under federal law, the company will lose its ability to rely on the Regulation D exemptions for securities offerings (the ones most commonly used for early stage companies raising money), making the offering itself an unregistered securities transaction.
Last, even if no current investor raises the issue, future investors looking back at previous financings may notice the mistake and price that risk into their valuation of the business or decide to pass on the investment altogether.
What Should I Do?
First, consider whether you need to bring on any outside person to help you raise your round. Using a finder or broker-dealer comes with economic costs: typically they’ll take a fee (paid in cash, equity or both) based on the amount of money they raise. And it can also come with reputational costs, since many investors don’t like the idea of entrepreneurs using finders to help with their fundraising efforts. But 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 large amounts of capital.
Second, confirm that anyone acting as a finder or broker-dealer is registered with the SEC, FINRA, and any applicable states. If they’re not, it generally would not be a good idea to hire them. FINRA’s BrokerCheck (brokercheck.finra.org) is a good resource for researching a broker’s background and registration status.
Third, if you still want to work with that individual, talk to your attorney about the best way to handle the relationship.
 Remember that “securities” doesn’t just mean “equity.” Selling company debt, including promissory notes, is also the sale of a security.
 Whether they call themselves a consultant or a finder or a fundraiser or anything else.
 We call this the “rising tide lifts all boats” securities exemption.
Christopher Poe is an attorney at Wyrick Robbins. His practice focuses on startups, helping businesses of all sizes and in all stages of development, from organization to exit. He assists startups with financings, including angel and venture fundings, and advises them on securities issues. You can email him at firstname.lastname@example.org.
The purpose of this brief is to provide general information, and it is not intended to provide, and should not be relied upon as, legal advice.