Many startups engage third-party consultants, or “finders”, to make introductions to potential investors. Startup founders generally have a technical background, and may lack meaningful connections in the finance/venture capital world, so they seek out these finders to assist in obtaining funding for their businesses. In exchange for the introductions to investors, the finder will take a fee, most often a percentage of the investment amount, and, in some cases, equity in the company. On its face this may seem like a beneficial relationship. However, startups considering engaging the services of a finder should be wary and ought to think carefully about the potential consequences of such an arrangement. Many of these finders or consultants meet the U.S. Securities and Exchange Commission’s (“SEC”) definition of a securities broker, but yet the vast majority of finders do not register with the SEC as a broker.
Under the Securities Exchange Act of 1934 (“Act”), a person must register with the SEC as a broker in order to sell securities. The Act defines a broker as a person “engaged in the business of effecting transactions in securities for the account of others.” The SEC and the courts have interpreted the definition of broker broadly. Simply, if the finder is soliciting investments (as opposed to purely making an introduction) and receiving transaction-related compensation, the finder is likely a broker under the Act and must register with the SEC.
At this point you’re probably thinking “Okay, so what? Why would I care if my finder is not actually registered as a broker?” The problem is that if your company engages the services of an unregistered broker to sell the securities of your company, the company faces potential SEC sanctions for aiding and abetting an unregistered broker.
These sanctions can have some serious bite. If the SEC determines that the company is aiding and abetting an unregistered broker, it can issue cease and desist orders directed towards the company. It can slap the company with fines and issue restraining orders or temporary/permanent injunctions from issuing securities. The SEC can even refer the company to the U.S. Department of Justice for criminal proceedings. In addition to federal penalties, many states have laws against hiring an unregistered broker, adding another layer of potential sanctions.
Finally—and potentially the most detrimentally to a company—Section 29(b) of the Act renders contracts involving a violation of section 15(a) voidable and provides for a private right of rescission for innocent parties. Translated to English, this means that the party that invested in the company would have the option to void the stock purchase agreement entered into as a result of the finder’s introduction.
Rescission of a funding agreement could signal trouble to other investors and cause funding to dry up completely, which would likely be a death knell to a young company trying to scale quickly. And at a minimum, rescission would represent a diligence red flag for future investors and/or purchasers, which will result in increased legal fees and additional time spent closing the deal.