On October 7, 2020, the SEC published a proposed rule to allow so-called finders to lawfully charge fees in connection with helping small businesses raise capital. You can read a press release from the SEC on the proposed exemptions here and you can read the entire proposed rule here. I previously wrote here about other recent changes made by the SEC to help small businesses raise capital by modernizing the definition of “accredited investor”.
I am regularly engaged as securities counsel for small businesses raising capital. Frequently, these small business owners turn to so-called finders for help because small business owners often lack the rolodex connections needed to raise capital themselves, and the relatively small size of these transactions is unattractive to registered broker-dealers. Unless structured properly, engaging a finder for help in raising capital presents risk to the small business and its owners.
Securities laws are technical and complicated. So some background on securities transactions and finders will be helpful. The concept of a securities transaction is very broad. The Securities Act of 1933 (the “Securities Act”) defines a “security” as
“any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a "security", or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
The intent is to capture all arrangements where a party (the investor) places something of value (usually money) with another party (the issuer of the security) in hopes of making a return off of the other party’s efforts or business. It comes a surprise to many entrepreneurs that stock in a start-up, membership interests in an LLC, employee stock options and even a simple promissory note are securities regulated by state and federal law. Under the Securities Act, a sale of a security must either be registered (a complicated and expensive process), qualify for an exemption from registration or is illegal. If you are raising capital in any manner other than a bank loan, you should assume you are selling securities.
Under Section 15 of the Securities Exchange Act of 1934 (the “Exchange Act”), any person that acts as a “broker” or “dealer” in securities in interstate commerce must register with the SEC. A “broker” is “any person engaged in the business of effecting transactions in securities for the account of others,” and a “dealer” is “any person engaged in the business of buying and selling securities (not including security-based swaps, other than security-based swaps with or for persons that are not eligible contract participants) for such person’s own account through a broker or otherwise.” Penalties for persons failing to register as a broker-dealer with the SEC can be severe, including civil monetary penalties, disgorgement of fees, bars from future securities activities and other consequences. The primary risk to issuers who engage such unregistered persons is the right of investors to rescind their investment.
Whether a finder is actually a “broker” or “dealer” required to register with SEC is a fact and circumstances inquiry based on the finder’s activities, with the most important factor being compensation. Under current policy, a person that is paid success-based compensation (does not need to be money, equity grants and other economic benefits are considered compensation too) to sell securities for an issuer, he or she almost certainly must register as a broker-deal with the SEC.
In practice, small businesses engage finders to raise capital in violation of the Exchange Act every day, and enforcement and penalties for violations rarely occur outside of the context of a securities fraud action initiated by a disappointed investor. Practitioners jokingly refer to this as the “good deal exemption” because investors don’t complain when the investment makes money.
Apparently recognizing the wide-spread use of (and need for) finders to help small businesses raise capital, the SEC recently proposed additional exemptions for certain finders. Under the proposed exemptions, a Tier I finder would be limited to providing contact information of potential investors in connection with only a single capital raising transaction by a single issuer in a 12 month period. Additionally, a Tier I finder could not have any contact with a potential investor about the issuer.
Tier II finders could solicit investors on behalf of an issuer, but the solicitation-related activities would be limited to: (i) identifying, screening, and contacting potential investors; (ii) distributing issuer offering materials to investors; (iii) discussing issuer information included in any offering materials, provided that the Tier II finder does not provide advice as to the valuation or advisability of the investment; and (iv) arranging or participating in meetings with the issuer and investor.
Both Tier I and Tier II finders would be subject to certain conditions. The proposed exemption for Tier I and Tier II finders would be available only where:
Further, a finder could not (i) be involved in structuring the transaction or negotiating the terms of the offering; (ii) handle customer funds or securities or bind the issuer or investor; (iii) participate in the preparation of any sales materials; (iv) perform any independent analysis of the sale; (v) engage in any “due diligence” activities; (vi) assist or provide financing for such purchases; or (vii) provide advice as to the valuation or financial advisability of the investment.
Because Tier II finders could participate in a wider range of activity and have the potential to engage in more offerings with issuers and investors, a Tier II finder wishing to rely on the proposed exemption would need to satisfy certain disclosure requirements and other conditions. These disclosure requirements, which include a requirement that the Tier II finder provide appropriate disclosures of the Tier II finder’s role and compensation, must be made prior to or at the time of the solicitation. Further, the Tier II finder must obtain from the investor, prior to or at the time of any investment in the issuer’s securities, a dated written acknowledgment of receipt of the required disclosures.
It is important to note that the proposed exemptions are not effective yet, and finders and issuers are still subject to current restrictions under the Exchange Act and applicable state securities laws.
The foregoing is merely informational in nature and is not intended as legal advice. Prior to raising capital or engaging a finder, consult competent legal counsel experienced in securities laws. Your business depends on it.
Edward R. Culhane is an experienced cannabis and hemp attorney focused primarily in the areas of venture capital, private equity, securities and mergers and acquisitions. Mr. Culhane is a cannabis and hemp industry veteran and is licensed to practice law in the states of California, Colorado and Minnesota. You can reach him at firstname.lastname@example.org or (612) 483-5385. www.culhanelawfirm.com
 Securities Act of 1933, § 2(a)(1).
 Securities Exchange Act of 1934, §3(a)(4)(A), 15 USC §78c(a)(4)(A).
 Id., §3(a)(5)(A), 15 USC §78c(a)(5)(A).
 Id., §29(b), 15 USC §78cc(b).
 Guide to Broker-Dealer Registration, Division of Trading and Markets, U.S. Securities & Exchange Commission, available at: https://www.sec.gov/reportspubs/investor-publications/divisionsmarketregbdguidehtm.html.