Hiring a Third Party to Raise Capital

December 6, 2021

At some point in the process of raising capital for your business, you may consider the idea of paying a third party to help you do so. If you decide to engage a third party to help you raise capital, you will need to understand the importance of whether or not that individual or entity is a registered broker-dealer. It is almost always unlawful to pay a finder’s fee or commission in connection with the sale of securities to a person who is not a registered broker-dealer registered with both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).

In this article, we’ll discuss the broker-dealer regulations and the exemptions available from the regulations.

What is the difference between a Broker-Dealer and a Finder?

The classification of an individual as a broker-dealer can have massive ramifications if that individual fails to register. Unregistered broker-dealers may be faced with significant fines, and transactions involving unregistered broker-dealers may trigger a right of recession for potential investors, requiring you to return the investors’ investment in full.

The SEC has distinct and separate definitions for which individuals and which actions may indicate classification as a broker or as a dealer. A broker, as defined by the SEC, is any individual who is “engaged in the business of effecting transactions in securities for the account of others.” Furthermore, the SEC defines a dealer as any individual who is “engaged in the business of buying and selling securities for his own account, through a broker or otherwise.”

On the other hand, securities law has not yet defined who falls into the category of finder, and as a result, does not need to register as a broker-dealer. A finder is simply an individual or entity whose actions do not rise to the level requiring broker-dealer registration. Therefore, we must try to determine what exactly will and will not classify one as a broker or a dealer if we want to understand who will be classified as a finder.

Historically, the most difficult distinction to make has been the fine line between finder and broker classification, and how to determine who qualifies as which. However, the SEC has provided some much-needed clarity for those trying to determine whether one is required to register as a broker-dealer or not.  Through analysis of various SEC no-action letters and other forms of guidance, we can shed light on what activities may increase or decrease the likelihood of an individual or entity being deemed a broker-dealer and require registration.

The following activities have been found in case law and no-action letters as indicative of those individuals who would not need to register as broker-dealers:

  • Aiding in the transfer or sale of all of a business’s equity securities and assets to a single purchaser or group of purchasers;
  • Being compensated purely for making introductions when such compensation is not dependent in any way on the success of those introductions leading to actual investment; and
  • Connecting issuers to investors without further influencing or advising potential future investment negotiations.

Conversely, the below activities have increased the likelihood of classification as a broker requiring registration:

  • Receiving transaction-based compensation in any amount that is tied to the success, size or type of potential investments;
  • Assisting in any capacity with the actual sale, negotiation or structuring of transactions between the issuer and potential investors;
  • Actively searching for new, potential investors or issuers;
  • Soliciting new clients;
  • Sending quotes for securities or other financing related documents to potential investors; and
  • Providing analysis or advice regarding potential investments.

As you can see, although no single activity or fact is determinative of how classification will be made, there is little one can do without potentially crossing over into registered broker-dealer territory.

What Fees Cannot Be Paid to Unlicensed Broker-Dealers?

receipt of the transaction-based fees has been given more attention than others by the SEC, that being the, as opposed to fees which are entirely independent of the outcome (i.e. success fees). The idea here is that this form of compensation creates a strong incentive to effectuate actual securities transactions, and one of the key purposes of broker-dealer regulation is to regulate those involved in the actual sale of securities. If an unlicensed individual tells you they can raise money on your behalf in exchange for a cut of the funds, they (and potentially you) are likely breaking the law.

In some cases, it is permissible to offer compensation that is not contingent upon the successful completion of a transaction to an unlicensed broker-dealer. The most common examples of fees of this nature include:

  • Fees based purely on making introductions;
  • Hourly consulting fees;
  • Fixed due diligence fees; and
  • Expense reimbursements.

With that being said, as a caution to the unwary, the SEC has made clear that just because one receives only the above fee types, thiese activities can still elevate one to broker-dealer status, particularly if one receives these fees repeatedly.  Alternatively, receiving transaction-based compensation does not always mean one is determined to be a broker-dealer. A totality of the facts must be considered in each circumstance to make an accurate determination.

Considering our discussion and analysis thus far, it can be quite difficult to tell the difference between a permissible fee and unlawful compensation. For this reason, it is rarely a good idea to hire an unregistered individual. However, if you do wish to enlist the services of an unlicensed individual or entity, you should consult with a knowledgeable attorney before signing any contracts or paying any fees to help ensure legal compliance.

What Are the Negative Consequences of Paying an Unlicensed Broker-Dealer to Raise Funds?

As we touched on before, paying an unlicensed broker-dealer to help you raise capital for your business can result in a wide range of negative consequences. Those individuals or entities who view themselves simply as finders often do not make the necessary considerations to actually determine whether or not they are in fact operating as unlawfully unregistered broker-dealers. It is crucial for you to make this determination independently.

If you do happen to pay an unlicensed broker-dealer, you may be subject to a wide array of negative consequences, such as:

  • Voided Agreements: Investors can often void agreements made in violation of state or federal law. In some jurisdictions, they can also claim interest and attorneys’ fees. If you have already spent their money, their request may bankrupt your company.
  • Lawsuits: It is not at all unusual for investors to file lawsuits against organizations and business owners that use unlicensed broker-dealers. Successful plaintiffs can recover tens of thousands or even millions of dollars in damages.
  • Fines and Imprisonment: If a state or federal law enforcement agency believes your actions were criminal, they may arrest you. If convicted, you could face a hefty fine or even a lengthy prison sentence.
  • “Bad Actor” Designation: The SEC may decide to label you a “Bad Actor” for paying an unlicensed broker-dealer. Should they choose to do so, you will no longer be able to participate in private placement offerings under Rule 506 of the Securities Act.
  • Difficulty Obtaining Future Financing: Irregularities in early fundraising activities can make it challenging to secure additional financing in the future. Investors usually do not want to do business with companies that have a history of unethical or illegal behavior.

These consequences have the potential to destroy your business and make your life extremely difficult. As such, it is generally advisable to not take the risk and avoid working with unlicensed broker-dealers.

How Can I Legally Raise Money for My Business?

Compensating unregistered individuals and entities requires careful considerations and, if handled incorrectly, can produce catastrophic results for you and your business.  Luckily, there are scores of lawful and effective ways to generate the capital you require without having to determine whether or not the individual or entity you are dealing with is an unregistered broker-dealer. Some individuals and financing options you may want to consider include:

  • Licensed Broker-Dealers: FINRA-registered broker-dealers can receive compensation for transactions involving the sale of securities. Hiring a licensed broker-dealer can help you raise the funds you need without inadvertently breaking any state or federal laws.
  • Business Loans: Banks, credit unions, and other financial institutions offer a variety of loans to companies like yours. To qualify, you will likely need to have been in business for at least two (2) years and have strong annual revenues.
  • Friends and Family: Section 4(a)(2) of the Securities Act allows you to offer securities to people you personally know. You can use this exemption to raise funds from friends and family members.
  • Accredited Investors: Venture capitalists and angel investors are always looking for new companies to back. If you can show an accredited investor a solid business plan and the ability to achieve it, they may decide to give you the funds you require.
  • Crowdfunding: With the right product and pitch, you may be able to raise funds from the public on Kickstarter, Indiegogo, or another crowdfunding website. You will not be able to sell stock in your company on these sites, however.

Raising money for a business requires careful consideration. Without taking the proper care, you could easily end up on the wrong side of the law. For this reason, it is always a good idea to consult with a knowledgeable business lawyer before moving forward with a funding round or engaging third parties to help. knowledgeable counsel will be able to review your plans, offer guidance, and ensure you do not inadvertently break any state or federal laws.


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