As a start-up company, one of the primary activities that will take up your energy is the task of raising funds. You will undoubtedly be knocking on many doors looking for avenues leading to the right investor. When it comes to fundraising, Silicon Valley is extremely relationship-based. By this, I mean most investors will require someone they trust to vouch for your company before a conversation will even occur with you directly. This can be seen in the way that successful entrepreneurs may go out of their way to help start-ups, including by introducing them to potential investors. While these successful entrepreneurs do often receive equity in exchange for serving on advisory boards and mentoring start-up teams, most do not ask for any compensation for making investor introductions. Furthermore, even if they are compensated (by cash or stock) solely for making introductions to potential investors, many investors will not invest unless such compensation is returned. The one question that the “pay it forward” culture often raises is whether introducing companies to investors requires introducers to take on the onerous task of registering as a “broker-dealer.” California recently enacted a new law (effective January 1, 2016) that provides an exemption for a “finder” from the broker-dealer certification requirements under the California Corporate Securities Law of 1968 (as amended). The purpose of the law is to provide guidance in securities transactions in California as to what may be permitted (and prohibited) finder activities for those persons who seek to act solely as a finder (and to issuers who seek to use finders). Further, the recent changes permit such persons to be compensated for those finder services, provided they satisfy the statutory requirements, without complying with the California broker-dealer rules and regulations. Additionally, it is envisioned that the new law may assist smaller companies that are seeking to raise capital by providing them with an additional permitted means of doing so. One point to highlight here is that if you are seeking to be a “finder,” in order to claim exemption from the broker-dealer rules and regulations, there are certain activities that you cannot engage in. This includes participating in negotiations, advising as to value of the securities, and taking custody of any funds in connection with the transaction, among others. Keep in mind that if introductions are made to investors in two or more states, the company will be subject to additional regulations of the SEC, and the securities regulations of multiple states.
Whether a person making introductions to potential investors qualifies as a broker-dealer, who must be registered pursuant to applicable securities laws, is important, as the consequences of illegally doing business as an unregistered broker-dealer include: (1) cease-and-desist orders from the SEC or relevant state regulator or court injunctions; (2) civil penalties, including fines and disgorgement of profits; (3) criminal liability; (4) potential rescission rights of investors under federal or state law; and (5) reputational harm. To avoid these possible consequences, a company should fully evaluate the activities of a person who makes investor introductions to ensure that such person qualifies for an exemption under the broker-dealer regulations.