Raising Capital? Make Sure You’re Not Breaking This SEC Compliance Rule.

Ignorance of the law is no excuse…

But there’s one SEC compliance rule that so many entrepreneurs and founders don’t know about that can lead to serious legal consequences. 

It all comes down to the difference between a “finder” and a “broker.” Who are you using when you’re trying to raise capital to grow your business? If you’re using a registered broker, you’re good. If you’re using a finder… you may be violating SEC rules and putting yourself and the finder at risk. 

Let’s look at how the law defines the two roles, how this issue can show up in your business, and how you can make sure you don’t find yourself in trouble with the SEC. 

Helping a Fractional General Counsel client comply with SEC rules 

At Kliebert Law, we work with a number of startups who are in the process of acquiring funding so they can scale. Our clients love having us on board as Fractional General Counsel because there are so many big decisions with legal implications that must be made in the startup and growth phases of a business. 

One of my clients started, as many startups do, with capital from “friends and family” type of investors. But when that money was gone, they decided to seek out a larger investor or two who could offer a serious cash infusion. 

We’re still in the “totally normal, lots of people do this” type of scenario, but that’s about to change. 

This founder had a professional contact who proclaimed to “know a lot of rich people” and offered to connect the founder with these “rich” friends in exchange for a percentage of the money any of his friends invested.

This feels like a typical exchange. But it’s not. 

At this point in the process, my client asked me to write up an agreement that stated the contact would be paid 3% for any capital investment of at least $1 million the contact brought to the table. 

I immediately recognized the issue here and said, “Absolutely not! You can’t set up this kind of arrangement. NO WAY!” 

Which led to some heated feelings in the moment before my client did some more research and realized I had just saved them from a huge SEC violation! 

Thankfully, I caught the mistake before it happened and was able to share other legal options for bringing in funding.

The difference in a finder and a broker

The SEC has strict compliance rules for “broker-dealers.” Many individuals approach start-ups offering their fundraising services as a “finder” or a “consultant” - but the SEC doesn’t care about the title they’re using. They care about the substance of the services these individuals are offering. And in most cases the SEC considers these individuals to be brokers. 

A broker must be registered with the SEC. Registered brokers are active participants in the investment process and often negotiate the terms of the investment and lead the transaction. This is a role that is heavily regulated by the SEC. 

A finder, on the other hand, simply makes connections between founders and potential investors. A finder is not registered with the SEC, which means if they cross over into ANY broker-dealer practices, they would be violating SEC guidelines. 

Finders cannot:

• Give investing advice

• Influence the investment terms

• Negotiate deals

• Be involved with preparing sales materials. 

In other words, if a finder does anything more than make an introduction, they are entering broker territory. As you might imagine, this line is crossed more often than not.

Another key area of difference is in how each role can be legally compensated. Be on the lookout for any deals in which payment is contingent on the success or size of an investment  (like the arrangement my client's contact wanted to set up). This immediately puts the work into the “broker-dealer” camp.

While brokers can be paid this way, finders can't. To keep things legal, finders are typically paid a flat fee per introduction or a set monthly fee, which they receive regardless of the outcome of any introductions they make. 

It's essential that founders understand the difference between a broker-dealer and a finder. You can use a broker and pay them a commission on investments they secure for you - as long as they are properly registered with the SEC and follow all regulations. And if you choose to work with a finder instead, be wary and make sure their involvement never crosses into broker-dealer status. Otherwise you could find yourself, your startup, and your contact in serious legal trouble. 

How to ensure you maintain SEC compliance

When you’re desperate for money to keep your startup going, the risk that you make a bad deal or run into legal complications increases. 

My #1 tip for anyone seeking funding is to STOP before taking any action or signing an agreement. Bad deals happen when you’re in too big of a rush to stop and consider all angles of a proposal. A truly interested investor isn't going to bolt because you took a few days to think things through.

And of course, get help when you need it. Many people simply don’t know that there’s anything questionable about paying someone for bring you an investor. It feels like a fair, normal arrangement! It's our job as your attorney to know these red flags and keep an eye out for them.

With a little knowledge, some due diligence, and a trusted Fractional General Counsel on your team to double-check your agreements, you can avoid any legal issues while raising the capital your startup needs! 

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