October 21, 2020
The Current Rule for Capital Raisers
When I field calls from potential clients (PCs) about raising capital for their ventures, the conversation without fail always turns to the subject of paying someone to raise capital for the company. There can be any of a number of reasons these potential clients would want to pay someone else a commission to bring in investors. It frees up time so they can concentrate on the business side of things instead of raising money… It could accelerate the capital raising and investing timeline… They may not have the connections to be of any help . . . and so on and so on.
Here’s a typical conversation with a potential client:
PC: Can I pay someone a commission to bring in investors?
Me: No. Not typically. Well, not unless they’re licensed broker-dealers.
PC: Isn’t it expensive to get licensed?
Me: Yep. And very time-consuming.
PC: What if they were family or friends? Any loopholes there?
Me: Definitely not. Actually, that would actually draw extra attention from the SEC. The SEC doesn’t like nepotism or cronies.
PC: What if I hired them on as an employee of the company?
Me: Probably not gonna make much of a difference. If you hired them as an employee, they still can’t receive a commission and their primary duty can’t be raising money. In other words, their pay can’t be tied to raising money. Raising money can only be incidental to their duties. Like take you for example. You’re the Managing Member or CEO of the company. You can raise capital for the company because it’s not your primary duty. Your primary duty is running the company. Even then, you still can’t receive a commission or any type of transaction-based compensation.
PC: What if I gave them ownership in the GP company (GP is the General Partner/Sponsor Company)?
Me; Fine, but you still can’t pay them a commission. And their capital contribution to the company in return for their ownership interest can’t be tied to bringing in investors. You starting to get the picture?
PC: I think so, but I’ve talked to a lot of private companies and it seems like everyone’s doing it. What about the old saying, “pigs get fat, hogs get slaughtered.” What if we were discrete about it? Do you think we’d run into trouble?
Me: Let me stop you right there. The SEC has an entire task force dedicated to hunting down “Private Placement Broker-Dealers” who are getting paid to solicit investors without a broker-dealer license. Not only have they ramped up their efforts but they’re casting a wider net by interpreting a lot more actions as involving the sale of securities that some people wouldn’t think would be included. In other words, don’t play with fire. The SEC isn’t messing around. It could mean substantial fines, being banned and in many cases going to jail. Hogs don’t just get slaughtered when you’re messing with the SEC, they get thrown into a wood chipper whole.
PC: Ok, ok. You made your point.
I hate to be the bearer of bad news, but I don’t want to see anyone going to jail. So to reiterate, people outside the issuing company can not receive any type of compensation for bringing investors to the issuer without being a license broker-dealer.
As for employees or principals, the question of whether such a person can bring in investors turn on these questions:
- What is the person’s primary duty? If the person’s primary duty is to clean bathrooms or any other duty besides raising money, the person passes this test. If the person’s primary duty is to raise money, you’re in trouble.
- Is the person paid transaction-based compensation? In other words, does the person receive a commission or flat fee per investor or investor dollar they bring in? If you answered yes, you’re in trouble.
Changes in the Air
Now, that I’ve scared you, let me give you the silver lining. The SEC has PROPOSED to relax the rules a little bit on allowing capital raising activities. This proposed exemption is in the early stages. It could be months before final regulations go into effect. Bottom line . . . DO NOT RELY ON THESE EXEMPTIONS YET TO RAISE CAPITAL.
What we Know
Just like it had done to relax the rules on advertising in connection with a private offering through Rule 506(c) of Regulation D, the SEC is now prepared to relax the rules on Finders (Finders), persons who “find” investors for private companies. It’s not a free-for-all. There are limitations. Here’s what we know so far. The proposed exemptions only apply to the solicitation of accredited investors, the issuer must be relying on a private offering exemption like a 506 offering under Reg. D and there are two sets of rules for two classes of Finders – Tier I and Tier II.
The Rules Applicable to Both Tier I and Tier II Finders
These rules apply to both Tier I and Tier II Finders:
- the issuer is not required to file reports under Section 13 or Section 15(d) of the Exchange Act (in other words, the issuer can’t already a public company)
- the issuer is seeking to conduct the securities offering in reliance on an applicable exemption from registration under the Securities Act (for example, Reg. D)
- the Finder does not engage in general solicitation (no advertising, cold calling, seminars, etc.)
- the potential investor is an accredited investor
- the Finder provides services pursuant to a written agreement with the issuer that includes a description of the services provided and associated compensation (in other words, can’t be just a handshake and a wink)
- the Finder is not an associated person of a broker-dealer (can’t be working for or be contracted with a broker-dealer); and
- the Finder is not subject to statutory disqualification, as that term is defined in Section 3(a)(39) of the Exchange Act, at the time of his or her participation (You haven’t previously violated securities rules or regulations).
Here are the differences between the rules for Tier I and Tier II Finders:
Tier I Finders
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. A Tier I Finder could not have any contact with a potential investor about the issuer.
In plain English, the Tier I Finder can only be referring investors over to ONE ISSUER FOR A SINGLE TRANSACTION OVER A 12-MONTH PERIOD AND THE TIER 1 FINDER CAN NOT TALK OR COMMUNICATE IN ANY WAY WITH THE POTENTIAL INVESTOR ABOUT THE INVESTMENT. This seems to me like a case of family and friends. A person will share the contact info. a family member with the issuer and receive some kind of compensation for the referral.
Can a Tier 1 Finder refer investors to two different companies during a 12-month period? NO
Can a Tier 1 Finder refer investors to the same issuer but for two different funds or offerings during a 12-month period? NO
Tier II Finders
A Tier II Finder 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.
Tier II Finders are given more leeway on the number of issuers and offerings they can raise capital for (currently, there are no proposed limits) and they’re given more freedom as to their interactions with potential investors.
TIER II FINDERS HAVE MORE FREEDOM BUT THEY’RE ALSO SUBJECT TO MORE REQUIREMENTS.
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 to provide appropriate disclosures to potential investors of the Tier II Finder’s role and compensation, which must be made prior to or at the time of the solicitation.
- 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.
What We Don’t Know
The summary above is what we know so far about the proposed exemptions permitting Finders in connection with a private offering. What we don’t know is if there will be restrictions on the type or amount of compensation. Are the Finders limited to a commission or flat fee? Is there a cap on this compensation?
What we also don’t know is the issuer’s disclosure requirements to its investors when it comes to these Finders.
Looks like there’s hope on the horizon for compensating Finders in connection with private placements. This would help out companies seeking capital immensely as it would open up the the investor pool and accelerate the capital raising phase of the venture.
LET ME BE CLEAR. THESE ARE JUST PROPOSED RULES. DO NOT RELY ON THEM TO RAISE CAPITAL.
In the meantime, stick to the current rules, which basically say that unless you’re a principal or employee of the issuer and your primary duties are not to find investors and you don’t receive transaction-based compensation, you can not raise capital for the issuer.