“And if you haven’t run a financing process before, it may seem like being on a different planet in a different language and set of customs and rules.” 

Traditionally, it’s been the job of the entrepreneur and the CEO to raise money to grow a business, so what should you be thinking about if you hire someone to do this for you?

There are several benefits of bringing in third parties:

• Expertise. The fundraising process takes experience. Third parties can bring the experience of the process that relieve a heavy burden on you including presentation preparation, financial modeling and much more.
• Relationships. Third parties that live in the funding world have established relationships with many types of funders from angels and angel groups, to venture capital, private equity and even family offices.
• Credibility. If you choose the right third party, this can bring credibility to your company. If your third party has a good reputation and especially for only taking on good companies as clients, this can lend credibility to your efforts.

Types of Third Parties

There are generally a few types of third parties you can hire to help you raise money:

• Finders. Finders are individuals that have an expertise and a network related to raising capital and play the role of opening up their contact list and making introductions to potential investors. Their role is limited to making introductions and facilitating connections. When finders go beyond this limited scope, they must be registered as a broker dealer (which we discuss in more detail later).
• Broker/Dealers.A broker-dealer is agent who assists a buyer and/or seller of securities in the fundraising process. This includes all of the following:
  • Negotiating the terms of the financing transaction
  • Offering or providing advice or recommendations in the financing transaction
  • Receiving success-based fees (i.e., fees contingent on the success of the financing transaction)
  • Providing issuing companies with assistance in drafting or distributing sales and financial materials
  • Soliciting investors
  • Handling funds involved in the transaction
  • Previous involvement and the frequency of involvement in the sale of securities
• Advisors. Advisors are individuals that guide you in the process and may also make introductions. They can be valuable, but like finders cannot provide the types of services or be compensated with a success fee without being a registered broker-dealer.
• Funding Platforms.These platforms – such as Funders Club and Angel List – connect companies with investors.
  • Funders Club. FundersClub posts information on its website about opportunities to invest in private companies. This information is available only to FundersClub members, all of whom have been pre-screened as accredited investors. Members can use the site to express a non-binding indication of interest to invest in a particular company.
  • Angel List. Angel List employs a similar strategy, helping accredited investors find companies that are seeking capital and in which one or more investors intend to invest. The distinction between the FundersClub and AngelList online matchmaking platforms lies in AngelList’s use of a “lead angel,” who identifies the start-up and structures the terms of the investment.

Legal Issue: When a Finder/Advisor Needs to Register

To begin, it is important to understand the distinction between a finder and a broker-dealer. Federal securities laws generally consider anyone who effects transactions in securities to be acting as a broker-dealer, requiring that person go through the costly and extensive process of registering with the SEC and the Financial Industry Regulatory Authority, or FINRA. Finders, on the other hand, are exempt from federal registration requirements. Securities laws do not specifically define the term finder, or what they can do. Here are some activities that finders can do without running afoul of the broker-dealer registration requirements:

• Make introductions (i.e., provide names and contact information). Introductions may only be made to prospective investors who the finder has a substantive and pre-existing relationship with and where the nature of the relationship enables the finder to be aware of the financial circumstances or sophistication of the prospective investor, or is otherwise of some substance or duration.
• Help Prepare Offering Materials (e.g, executive summaries and placement memorandums). Note that the finder may not present such materials to investors or negotiate such materials.
• Help with Administration. Help with administrative matters.
• Received Non-Success Based Fees. Receive a fixed fee or hourly compensation, so long as it is not contingent upon (or tied to the success of) an investment being made.

If you have engaged a finder who is conducting any of the following activities without an active broker-dealer registration, then your company could face legal and regulatory issues (as discussed below):

• Transaction-based Compensation. Engagement involves receipt of transaction-based compensation or “success fees.” For example, compensation or success fees are calculated based on a percentage of the amount of money raised.
• Negotiating. Involvement in the negotiation of financing documents related to the purchase and sale of securities.
• Advice. Involvement in negotiations with or provision of detailed advice or information to a buyer or seller of securities.
• Solicitation. Solicitation of investors.
• Prescreeing. Pre-screening potential investors to determine their eligibility to purchase securities and to gauge investors’ interest.
• Coaxing Investors. Persuading or incentivizing an investor to purchase a security.

As an entrepreneur, you need to tread carefully when deciding whom to hire as a broker. The vast majority of individuals who present themselves as financing consultants and/or “advisors” are not licensed brokers.

If you have hired a licensed broker-dealer to assist you with your financing, then you should confirm the status of their broker-dealer license through FINRA’s Broker Check system – BrokerCheck: Research Brokers & Investment Advisers – FINRA .If you don’t see their name in the database, don’t do business with them.

What about funding platforms?

Even though funding platforms like Funders Club and AngelList are third parties that could technically be required to register, the SEC has indicated that these platforms are not required to do so. The SEC said:

“running a platform that connects investors with private funds and qualifying investors would not, by itself, require broker-dealer registration, as long as there were not other indications of broker-dealer activity, like transaction-based compensation.”

For now platforms like Funders Club and Angel List are exempt from registration.

Finder Issues

There are many finders – some which are reputable and highly competent and others which are substandard. Startups that engage finders have to consider the following issues:

• Unmet Expectations. Founders often are optimistic at the beginning of the relationship, only to be left with unmet expectations, unsatisfactory results (i.e., little or no money is raised)
• They Are Not Registered. More often than not, finders are providing services that require them to register as a broker-dealer (which we discuss in more detail below) – which is illegal. The vast majority of individuals who present themselves as financing consultants and/or “advisors” are not licensed brokers. They may have letters after their name like CPA or CFP, but that may not entitle them to get paid for introductions to investors–particularly if this is part of their core business. Make sure you have a consulting agreement in place with the finder, documenting your relationship and specifying what the finder is expected to do and, importantly, what the finder is prohibited from doing.
• Do Your Homework. Make sure the person or firm that you are working with is credible. Ask for references from both clients that were successful and ones that were unsuccessful.
• E-mail. Be leery of brokers who use free email services such as Yahoo or Hotmail or even AOL. Legit service providers should have their own domains.

There are a range of “finders” out there in the startup world, so be thoughtful as you evaluate your financing opportunities and the people who will help your company raise money.

Broker Issues

While registration as a registered broker-dealer is expensive and is generally a pretty good indicator of the quality of a broker, much like finders, there is a range of considerations when hiring a broker:

• Cost. Brokers are expensive, so chose wisely.
• Industry Knowledge. Take a look at their track record and make sure they understand your industry really well, particularly if you are looking for a strategic investment.
• They Can Add Value. They can work with you to polish your business plan, teaser, pitch-deck, advise you on a business model.
• The Bigger the Better. Brokers are the most useful for growth stage companies that are looking to raise Series C, D round of $20M or more. Such company is fairly established, has a CFO that can quickly provide all pro-forma statements, so broker can speed up the transaction.
• Do Your Homework. Make sure the person or firm that you are working with is credible. Ask for references from both clients that were successful and ones that were unsuccessful.
• Protect Your Money. If the broker looks legit insist that any and all fees be held by your lawyer until the funds are securely in your bank account.
• Conflict of Interest. Understand the conflict-of-interest ramifications before you sign any agreements. Your broker has an economic incentive to get you funded. You have an economic incentive to grow your business properly. At times, these incentives don’t match. For example, your broker may refer to you to investors who are not ideal for your business or your broker may tempt you to take the first deal you’re offered. A good broker will work with you to find the right investor, but it’s very difficult to sort the good from the bad in the murky world of investment brokerage for small-scale companies.

You pay more to get more with a broker, but they also need to be vetted to make sure they are a good fit.

Investor Perspective

Some investors will be turned off, but more will be turned on by the use of third parties. There’s a widely held myth among small-business owners that if they hire a financing broker, potential investors will think less of their business or their abilities as an entrepreneur. While some investors avoid businesses that come from brokers as a matter of policy, most don’t. Savvy investors recognize that brokers play a useful role. The skills it takes to build a solid business and manage people may not be the same skills required to network among private investors and build a funding pipeline. But there’s no doubt that you’ll hear some investors tell you it reflects badly on your business.

Standard Compensation of Third Parties

The following are the standard compensation arrangements with third parties and the associated issues:

• Finders.Generally, finders will want a retainer fee plus a success fee paid if and when they raise the money.
  • Retainer. Typically, a finder will charge a modest retainer of $2,500 to $5,000 a month.
  • Success Fee. Their success fee can range from a low of 4 percent of the total amount money raised to a high of 10 percent.
    • Credit for Retainer. Some will credit their retainer against the success fee, but that only helps if the goal is reached.
    • What Fee? Establishing the correct percentage fee is based on several factors, including the amount of the financing needed (brokers generally get a lower percentage for larger rounds of financing), the state of the capital market (brokers take a lower percentage when capital is flowing), and the extent to which the business is ready to be financing (you’ll pay a lower percentage when the fundraising package is compelling).
  • Minimum Commitment. 3 to 4 month commitment.
• Brokers.Typical broker compensation has several elements:
  • Retainer. They will ask for a monthly retainer that can range from a few hundred to ten thousand dollars per month.
  • Success Fee. Fee of 3 to 5 percent of funds raised.
  • Minimum Commitment. Six months commitment,
  • Expenses. Paid travel and other expenses incurred on your behalf.
  • “Tail.” Brokers will include a provision that requires you to pay them their success fee if you raise money from a party they introduced you to after you termination the agreement. This tail can be as short as six months and as long as two years.
• Advisors. If a person willing to make introductions on your behalf is genuinely interested in your success, give some equity in return to let them know that you appreciate their time. If this person is actively making introductions on your behalf, make them an advisor and give them equity appropriate to their contribution level (anywhere from 0.10% to 1.00%). Or you can compensate for their time with a monthly retainer.
• Success Fees. Here are some common guidelines for success fees:
  • Lehman Formula. 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
    • 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.
  • Another common formula provides for a fee of 5% of the first million and 4% of the next $10 million.
  • Big Ramge Based on Factors. Despite some guideposts, there is 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
• General Guidelines. Whether it is a finder or a broker, here are some general guidelines in negotiating
  • Try to Remove or Minimize Retainers. Do what you can to eliminate or reduce retainers. That being said, be wary of firms that will quickly waive retainers as it may be an indication that they are not in demand.
  • Set Performance Standard for Retainers. Require them to meet minimum performance goals, such as a minimum number of in-person introductions to investors or milestones related to the work that needs to be done (such as a broker completing a financial model).
  • Pay off “Net” for Success Fees. Note that the industry standard is to pay the percentage fee net of any retainer payments. In other words, if you’ve already paid $10,000 in monthly retainer payments, you would subtract $10,000 from the total fee due to your broker when the money is raised.
  • Expenses. Require your approval for expenses over $250.
  • Minimize the Tail. Minimize the tail period – the period during which you need to compensate a broker for a closed transaction wit an investor they introduced you to post-termination of your agreement with them – to as close to six months as you can.
  • Commitment. Keep the minimum commitment to as short as you can, such as three months. Finders may go for this while brokers may require six months.

There is some work to do to find the right third party to help you. If you do find the right fit, it can advance your fundraising process.