Posted on July 21, 2015
How a Finder’s Agreement Could Ruin Your Startup’s Chances of Getting Funded
Finding money is hard, so it’s common for a startup to use a “finder” to locate potential investors or partners.
Unfortunately, using the wrong kind of finder, or the wrong kind of finder’s agreement, could lead to disaster.
Doing it wrong could let your investors take back their money. Worse, your company could be prevented from EVER getting funded. Here’s why.
Obviously, a finder will expect to be compensated for finding you money. An agreement between a company and a finder that deals with this compensation (and other issues) is called (duh) a “finder’s agreement.”
A typical compensation clause might go something like this:
Should an Investor invest in Client’s Company, then Client agrees to pay Consultant six percent (6 %) of the amounts invested by Investor.
Here’s what the compensation clause in a finder’s agreement looks like when highlighted by LawGeex:
How much do you have to pay a finder?
One industry standard in the US (the Lehman Formula) uses the following scale:
- 5% finder’s fee on the first $1 million raised
- 4% on the second million
- 3% on the third million
- 2% of the fourth million
- 1% for more than $4 million
Another common formula provides for a fee of 5% of the first million and 4% of the next $10 million.
These numbers are based on payments in cash. For payments in stock (equity), the percentages are often doubled. It’s also common to see a mix of cash and equity.
However, in the finder’s fee contracts we’ve reviewed, we’ve seen a big range in finder’s fees. The share can depend on things like:
- Company status
- The finder’s power
- The specific industry
- The company’s geographic location
So what’s the problem?
The problem is that some finders – especially “professional” finders – may be violating federal and state securities laws.
As this useful article notes:
It is a common misperception among entrepreneurs and finders that the payment of a fee in cash or equity is acceptable if the finder merely makes introductions. This is wrong. It is a myth perpetuated by entrepreneurs and finders who have not been caught.
It’s forbidden to pay a finder a fee based on the amount of capital the finder brings to the company.
But didn’t we just talk about percentage fees and the Lehman Formula? So how can it be forbidden to base fees on the amount of money raised?
The problem is that some kinds of “finding” are regulated by securities laws. And if you use a finder who’s not a registered broker, you need to be extra careful about how you do it.
What’s the worst that can happen?
Unless a finder is licensed as a broker-dealer under US and state securities laws, a finder’s agreement could be illegal and unenforceable.
That might not sound so bad. In fact, it might sound like a great deal — the startup gets to keep the investors’ money but doesn’t have to pay the finder? Sweet!
Sorry. Doesn’t work that way.
If you fail to disclose that you’re using an unlicensed broker as a finder, you may be giving the investors the right to take back their investment.
As a useful blog notes:
Numerous securities laws, both state and federal, give investors rights to recover their investments if anyone who sold the investments materially misled the investors or omitted any information that makes the provided information materially misleading. An investor could argue that both the finder and the issuer misled the investor by not informing the investor about the protections that broker-dealer licensing is intended to provide, and omitting the fact that the finder is not licensed.
Some investors may decide to stick with the deal, but others may use this revelation as an excuse to get out.
But it gets worse….
As this article notes,
A common sanction sought by the SEC against issuers utilizing unregistered finders is to bar the issuer from conducting Regulation D offerings in the future. This, of course, could have a lethal effect on a start-up company dependent on private capital.
(Regulation D includes the rules that allow some companies to offer and sell their securities without needing to register the securities with the SEC. This makes access to capital markets possible for smaller companies that couldn’t afford SEC registration.)
In addition, a company that improperly uses a finder could be liable for aiding and abetting securities laws violations.
A Finder’s Agreement That Won’t Blow Up in Your Face
With so much at stake, it’s not a good idea to sign some random finder’s agreement you pull off the internet and don’t really understand.
You can consider options like:
- Making sure your finder is, in fact, a registered broker-dealer
- Making sure your finder will only do things that don’t require registration as a broker
- Paying a finder a fixed-fee regardless of the outcome of the finder’s introductions
Get Your Finder’s Agreement Reviewed Fast
If you’ve already got a draft finder’s agreement and want to understand it better and see if it includes any non-standard clauses, you can get it reviewed fast with LawGeex.
The information and materials in this blog are provided for general informational purposes only and are not intended to be legal advice.