Raising capital is one of the most difficult challenges businesses face. It becomes even more challenging if the amount sought (e.g., less than $5 million) is below a level that would attract venture capital or a registered broker-dealer, but beyond the levels that can be provided by friends and family and personal financing.
One of the most frequently asked questions of a Securities Lawyer is if issuers are able to use a finder to help raise capital. A finder is generally a company, service or individual who identifies investors for a financing transaction. Finders usually receive a fee for introducing the parties and generally step away from the transaction after such preliminaries. A finder is different from either the term “broker” or “dealer.”
While the use of finders is widespread, the use of unregistered finders by businesses seeking capital is risky and poses two potential problems. First, a business (issuer) may not rely on a securities exemption if the finder did not strictly follow all applicable requirements for the exemption. Second, the issuer may not be able to use a planned securities exemption if it uses a finder that should be, but is not, registered as a broker. Prior to the proposal identified below, the circumstances allowing the appropriate use of finders was very limited.
On October 7, the United States Securities and Exchange Commission announced a proposal that would offer a non-exclusive and conditional safe harbor exemption from the broker registration requirements for the Securities Exchange Act of 1934 to permit natural persons to engage in certain limited capital raising activities involving only accredited investors (as that term is defined in Rule 501 of Regulation D). This proposal proposes to exempt two classes of finders, Tier I and Tier II, based on the types of activities in which finders are permitted to engage, and with conditions tailored to the scope of activities.
The proposed exemption for either tier of finder would be available only where:
- The issuer is not required to file reports under the Securities Exchange Act of 1934;
- The issuer is seeking to conduct the securities offering in reliance on an applicable exemption from registration under the Securities Act of 1933;
- 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 provides services pursuant to a written agreement with the issuer that includes a description of the services provided and associated compensation;
- The Finder is not an associated person of a broker-dealer;
- The Finder is not subject to statutory disqualification at the time of his or her participation.
Tier 1 Finders:
Under the proposal, a Tier 1 Finder is defined as a finder who meets the above conditions and whose activity is limited to providing contact information of potential investors in connection with only one capital raising transaction by a single issuer within a 12-month period, provided the Tier I Finder does not have any contact with the potential investors about the issuer. The contact information may include, among other things, name, telephone number, e-mail address, and social media information. A Tier I Finder that complies with all of the conditions of the exemption may receive transaction-based compensation (e.g. a commission in the form of a percentage of capital raised by the issuer from those potential investors introduced to the issuer by the finder) for the limited services described above without being required to register as a broker under the Securities Exchange Act of 1934.
Tier 2 Finders:
The proposed exemption permits Tier 2 Finders to engage in additional solicitation-related activities beyond those permitted for Tier 1 Finders. Under the proposal, a Tier 2 Finder is defined as a finder who meets the above conditions, and who engages in solicitation-related activities on behalf of an issuer, that are 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.
A Tier II Finder wishing to rely on the proposed exemption would need to satisfy certain disclosure requirements and other conditions. The Tier II Finder would need to provide a potential investor, prior to or at the time of the solicitation, disclosures that include: (i) the name of the Tier II Finder; (ii) the name of the issuer; (iii) the description of the relationship between the Tier II Finder and the issuer, including any affiliation; (iv) a statement that the Tier II Finder will be compensated for his or her solicitation activities by the issuer and a description of the terms of such compensation arrangement; (v) any material conflicts of interest resulting from the arrangement or relationship between the Tier II Finder and the issuer; and (vi) an affirmative statement that the Tier II Finder is acting as an agent of the issuer, is not acting as an associated person of a broker-dealer, and is not undertaking a role to act in the investor’s best interest.
The proposal contemplates that this disclosure be made orally and supplemented by a written disclosure delivered to the potential investor no later than the date the potential investors invests in the issuer. In addition, the proposal required that a 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. A Tier 2 Finder complying with all of the conditions of the exemption would also be able to receive transaction-based compensation.
A finder could not be involved in structuring the transaction or negotiating the terms of the offering. A finder also could not handle investor funds or securities or bind the issuer or investor; participate in the preparation of any sales materials; perform any independent analysis of the sale; engage in any “due diligence” activities; assist or provide financing for such purchases; or provide advice as to the valuation or financial advisability of the investment. The proposed exemption would apply only with respect to the defined activities for each tier of finder and is limited to activities solely in connection with primary offerings.
Additionally, the proposed exemption would not permit a finder to engage in broker activity beyond the scope of the proposed exemption, such as to facilitate a registered offering, a resale of securities, or the sale of securities to investors that are not accredited investors or that the finder does not have a reasonable belief are accredited investors.
The proposal is not yet final and is now subject to a 30-day comment period prior to United States Securities and Exchange Commission finalizing the proposed exemption.
While the enactment of this new proposal would be a major win for issuers, issuers will want to continue to be extremely cautious in their selection of a finder to assist in a capital raise as the failure of the finder to comply with any enacted proposal could still have negative consequences for the issuer. Securities lawyers with be creating finders agreement that incorporate instructions and representations for the finders that they are complying with the provisions, but this will remain the issuer’s risk. As with this and any securities matters, issuers should engage competent securities legal counsel to assist with securities transactions.
Coni Rathbone and Jason Powell are attorneys at Dunn Carney LLP, which recently opened an office in Eagle. Dunn Carney advises businesses and individuals in real estate, Opportunity Zones, business, tax and securities matters, as well as litigation, and estate planning and administration.