Paying Contingent Finders Fees Or Success
Fees For Investors In Your Startup Company Are Illegal
One of the biggest, and most dangerous, misconceptions by entrepreneurs and startup companies is that they can pay a contingent finder’s fee or success fee for raising their investor capital.
You need to know that you cannot pay contingent finders fees or success fees…to me or to just about anyone…for finding investors for your startup company for your Reg D fundraising. This applies to both the old 506(b) and the new crowdfunding 506(c) Reg D offerings.
Paying contingent finder’s fees or success fees are violations of both state and federal securities laws – and both you and I could have a very serious problem with legal action, very hefty fines and penalties… And even jail.
I don’t know about you but I don’t want to end up in Martha Stewart’s old jail cell that was her required residence as a result of her felony conviction!
Whether we work together or not, this is something you really need to know and understand to protect yourself: Contingent commissions, finder’s fees, success fees, or whatever you want to call them, can only be paid to NASD broker-dealer firms OR Registered Investment Advisors OR, in the case of a Title III offering, a funding portal that is registered with the SEC and a member of a registered self-regulatory organization (SRO). Currently, the SRO is the Financial Industry Regulatory Authority (FINRA).
There is no federal securities law exception for 506 Reg D – even with the new equity crowdfunding offerings. Any payments of ANY contingent finders fees – besides those three exceptions – are a direct violation of both state and federal securities law. Period.
Hopefully, knowing this will help you from getting into very serious trouble with any of your current or future offerings.
Usually, neither the various state securities boards nor the SEC throws folks in prison for a first-time violation (unless there is fraud involved.)
However, what does very often happen is that the company is forced to “rescind” its offering. This means the company has to give back 100% of all investments made by ALL investors – and sometimes even pay back interest on top of that. Sometimes, the penalties include that the executives of the company are even barred for life from ever raising investor funds again.
This rescission penalty gets to be a real, major problem – especially if the company has already spent some or all of the money!
Another kind of penalty that may be delayed a few years: You raise your money – with just a small amount being raised by paying contingent finders or success fees. You’re successful and you get ready for an IPO or to have your company acquired for a lot of money. Except…the required due diligence uncovers that you paid an illegal finder’s fee – and that kills the deal and you end up with a lot of unhappy investors.
Bottom line: Do not pay any kind of contingent fundraising fees, commissions, success fees, etc. to anybody other than an NASD broker-dealer or an SEC Registered Investment Advisor or a funding portal that is registered with the SEC and a member of a registered self-regulatory organization (SRO).
If you want to hear the opinion of two securities attorneys on this issue, check out this great web page on the subject, please be sure and click: “Can a Startup Pay a Transaction-Based Fee or Commission to Someone Who Helps Raise Capital?” by attorneys Clifford A. DeGroot and Michael C. Phillips from the law firm Davis Wright Tremaine LLP.
What they’ve written is so important that some of it in particular bears repeating verbatim from their webpage:
What Possible Liability Is There for Using an Unlicensed Broker-Dealer to Raise Capital?
Using a finder may create liability under federal and state law. Agreements for the sale of securities made in violation of federal law may be held void. This would certainly apply to the agreement with the unregistered broker who attempts to collect a fee for assisting in the sale of the securities.
While the startup may feel that this is not such a bad thing, a violation of federal securities laws also may void (or make voidable) the agreement between the startup and investors under which the startup raised the funds. If the agreements are held void by a court, then all parties to those agreements would have a right of rescission that would last for the later of three years from the transaction or one year from the date the violation is discovered.
A right of rescission is simply a right to cancel the agreement and return each party to its original position, which means returning investments back to investors. In other words, the use of a finder who is not but should be a registered broker-dealer in effect gives the investors a multi-year redemption right.
Many states have similar rules. For example, violations of Washington’s securities laws provides a private right of rescission that includes 8 percent interest and reasonable attorneys’ fees.5 Similarly, Oregon investors can seek rescission of the transaction plus 9 percent interest (or greater) plus attorneys’ fees.
A violation of Oregon’s and Washington’s securities laws is made even more scary by the fact that Oregon and Washington investors can hold personally responsible for the violation any person who directly or indirectly controls the startup. In other words, investors in an offering that violates Oregon or Washington securities laws can sue founders personally to recover their investment plus interest plus attorneys’ fees.
Are There Other Potential Consequences of Engaging an Unlicensed Broker-Dealer to Raise Capital?
Yes, otherwise we would not have posed the question. Founders who engage unregistered broker-dealers to raise capital may:
- Face enforcement actions from the SEC as an aider and abettor;
- Face enforcement actions from state securities regulators; and
- Be labeled a “bad boy” and prohibited from participating in or being involved with companies that do a securities offerings made under commonly used securities exemptions.
Additionally, the startup itself may be prohibited from doing a Rule 506 securities offering, which is the most commonly relied-upon securities exemption for startups and emerging growth companies. And, just because the list goes on, the use of an unlicensed broker-dealer could impact the ability to close future rounds of financing because of the contingent liability associated with the initial violation, which is likely to come up in investor due diligence.
Hopefully we have your attention!
All of this should scare the pants off of you if you’re even considering paying finder’s fees or success fees for raising your investor capital!
Since it is illegal for me to accept, and for you to pay, a contingent payment, all of my work for my clients is at my standard billing rate strictly as a management consultant. As a way for both of us to be protected and to avoid any hint of contingent payment, I also require a 10-hour retainer at my standard billing rate of $250 per hour to commence working together.
This issue of contingent payments for fundraising is just one of the umpteen stumbling blocks that can trip you up between now and your funding success. This is one of the very reasons that I offer my Funding Foreplay Service – to keep my clients out of trouble and to make sure that they properly and legally romance prospective investors when they do find them.
If that sounds good, please click Phone Robert and give me two or three times that work for you this week for an introductory phone call. Hopefully, we can find a mutually workable time to set up a call in the next few days.
All the best,
Robert
Robert Lee Goodman, MBA
CEO & Chief ImpleMentor
CEO RESOURCE LLC
727.466.5200
Elevator Pitch: “I Help Startups Start and Stay Started” With My Services – And My Network of 16,900 Angel Investors.
PS: Although I was the past Founder and CEO of my own NASD broker-dealer firm, Goodman Securities Inc., I am NOT an attorney – and I am no longer in the securities business. The above is strictly business advice to try to keep you out of major trouble. Be sure and talk with your own securities attorney about these issues to make sure you’re not violating the law.
PPS: So you live in California and want to try and tap the state’s exemption for paying finder’s fees under the new AB 667 law? Then you better check out what law firm Holland & Hart has to say about the major risk factors to you, the company: Reasons to be Wary of California’s Finder Exemption. For the issuer (that would be your company): “As to the issuer, consequences can include anything from being held criminally and civilly liable as an aider and abettor of the unregistered broker-dealer activity to being forced to offer rescission to all investors introduced to the issuer by the unregistered broker-dealer.” Another possible impediment to the use of the exemption: The lack of a corresponding federal exemption.
PPPS: Fundraising can be pretty treacherous waters for your startup. All of this can be incredibly complex and complicated and frankly overwhelming – which are some of the reasons why I offer my Funding Foreplay Service to companies like yours. If you have never raised investor funds before, it is critically important to make sure you have a very experienced guide to help keep you from making critical, existential mistakes on your path to successful funding!
For the past three decades, I have focused solely on helping startups and emerging companies with their business planning, fundraising and implementation. During that time, I’ve already directly helped THOUSANDS of diverse startup companies and their CEOs, in 49 of the 50 states, in more than 70 countries and on six of the seven continents in more than 200 different industries.
How can I best help you and your company?