Sometimes a company will engage a “finder” to help it find financing. I always tell founders that they should confer with the company’s legal counsel when considering whether to engage a finder. If a finder is actually acting as a broker-dealer, and it is not registered, the result can be that the investors sourced by the finder has rescission rights.
Under federal securities laws, a broker is defined as “any person engaged in the business of effecting transactions in securities for the account of others.” ((Section 3(a)(4)(A) of the Securities Exchange Act of 1934 (the Exchange Act”).)) Effecting transactions in securities is interpreted broadly, and it can include activities ranging from “soliciting” potential investors to negotiating the sale of securities with prospective investors. Federal securities law also require that brokers and dealers register with the SEC. Failure to register can result not only in the contract between the issuer (i.e., the company) and the broker-dealer being voided, but also the securities purchase agreement between the issuer and the investors sourced by the broker-dealer being voided. Such investors would then have a rescission right – i.e., the right to have the issuer repurchase their securities.
The word “finder” implies merely finding potential investors. And if the finder is merely making introductions to potential investors, then such a finder may not be seen as a broker-dealer by the SEC. However, most finders I have come across do much more than this. They oftentimes provide potential investors with extensive information regarding the issuer or the securities offering or even actively market the issuer or its securities to such potential investors, which can be regarded as forms of solicitation. They are also often compensated based on a percentage of the funds they source. The SEC considers this type of transaction-based compensation as a key factor in determining that a person is acting as broker-dealer.
Using a finder that is an unregistered broker-dealer can also lead to problems with state securities regulators. States, including California and Washington, generally define broker-dealers similarly to the federal government and require them to register with the state. In California, an investor who purchases a security from an unlicensed broker-dealer is entitled to rescission or, if the investor no longer holds the security, for damages!
Note also that future investors may be hesitant to invest in a company that has run afoul of federal and state securities laws or whose existing investors have a rescission right that allows such existing investors to exit the company with their money before such future investors get liquidity.
Entrepreneurs should be sure to consult with their companies’ attorneys when engaging finders. Note only can the attorneys explain the risks of engaging a finder, but they can also draft a finders agreement that appropriately protects the company.
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