On October 7, 2020, the Securities & Exchange Commission (SEC) published its proposed rule exempting under certain circumstances people they define as “Finders” from the requirements of the SEC´s broker-dealer compliance regime.
Practically speaking, this means that if the proposed rule is adopted in its proposed form, early stage companies and startups will be able to pay commission-based compensation to those referral sources who help them raise capital for their businesses through referrals and contacts.
This is a big development. Compare this to the existing rule that would be modified by this proposal which currently prohibits incentive-based compensation or commissions to finders and referrers. As things currently stand, early stage companies and startups are severely hamstrung in their capital-raising efforts. They basically need to hire expensive brokers with appropriate licenses to finance their businesses if they do not have financial backers within their personal networks.
Under this new proposed rule, companies would now be able to pay incentive-based compensation to those who are able to provide them leads and connect them with investors even if they are not licensed broker-dealers. The SEC refers to these individuals as “Finders.” In the proposed rule, the SEC set up two tiers of Finders (Tier 1 and Tier 2).
Tiers of Finders
Tier 1 Finders are people who just provide contacts and do not talk to potential investors about specific investment offerings. Tier 2 Finders are those Finders who set up more substantial relationships for the companies they refer potential investors to and actually discuss the opportunities that companies offer with the potential investors.
General Rules Applicable to Finders
Under the SEC´s proposed rule, the following rules apply regardless whether someone is considered a Tier 1 or Tier 2 Finder:
Not an SEC Reporting Company. The company cannot already be an SEC Exchange Act Reporting Company.
Registration Exemption Available. The company must be relying on and complying with an SEC registration exemption for selling an investment in the company.
No General Solicitation. Finders cannot “generally solicit” investors. This means they have to only introduce companies to people in their existing networks. They cannot send mass emails, promote offering on social media or through any other mass marketing efforts.
Potential Investors Must Be Accredited Investors or Reasonably Believed to be Accredited Investors. Finders can only talk to people about the offering that they know or reasonably believe are accredited investors. Finders may also be responsible for providing companies documentation about the investors and supporting their conclusion that someone is accredited or reasonably believed to be.
Written Agreement Required. The Finder must have a written agreement with the company that describes services to be provided and compensation.
Not Disqualified. The Finder cannot already work with a registered broker-dealer or be deemed a so-called “bad actor”.
Tier 1 Rules
In addition to meeting the general rules above, Tier 1 Finders are limited in that they cannot actually discuss any proposed offering of a company that will pay them incentive-based compensation with potential investors. Tier 1 Finders, simply stated, are the “sell your contact list only” Finders.
Tier 2 Rules
Tier 2 Finders and how they work with companies gets a bit more complex, with an additional host of requirements coming into play. In addition to the general rules above, the following apply to Tier 2 Finders:
No Investment Advice. The Finder cannot provide advice as to the valuation or advisability of any investment. Any presentation will have to be neutral and informational in nature only.
No Negotiating or Agreeing to Terms. The Finder cannot be involved in structuring the transaction or negotiating the terms of the offering and cannot bind the company it is assisting to any terms.
Must use Company Sales Materials. The Finder cannot participate in the preparation of any sales materials or modify those that the company it is assisting provides them.
Proper Disclosure Required. Finders will have to follow our protocols with respect to (1) disclosing their relationship with the company and compensation to be received to potential investors and (2) getting acknowledgements from investors that they understand the relationship.
No Handling Funds. The Finder cannot handle customer funds.
No Lending. The Finder cannot provide financing for any investor purchases.
Agreement Required before Beginning. The Finder cannot begin talking to investors until they have entered into a formal agreement with the company they are assisting covering the foregoing. The Finder will have to covenant to comply and have complied with all of the foregoing rules and requirements. Finders will be solely responsible for any failure to comply.
So What’s Next?
The proposed rule is in the 30-day comment period with the SEC for the proposed exemption. We are optimistic, however, based on our experience, that the SEC is likely to adopt the proposed rules here subject to some clarifications received from practitioners and interested persons during the comment period.
This is an incredibly important development for startups and early stage companies as they continue to explore new ways to finance their businesses. Despite the requirements set forth above, this is a substantial development with respect to easing the requirements for startups and early stage companies to access the private capital markets.
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