Editor’s note: After more than a year-long “break” in Iraq, Matt Storms is ready to continue his series of columns about raising capital. His previous columns covered due diligence and corporate clean up, the mechanics of raising capital, and Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) grants. We thank Matt for his service, and we thank him for the following advice to Wisconsin entrepreneurs.
Once you complete your due diligence and corporate clean up and you have decided that your company is ready to raise capital, the obvious next question for most is where to find it. Many technology-based companies consider SBIR, STTR, Advanced Technology Program, or other government grant programs. For a variety of reasons, grants are not always a viable, sufficient, or perhaps timely option for many companies. In fact, businesses frequently raise money from friends and family. Usually, however, that is not sufficient to fund the needs of a growing technology company. As a result, most technology companies look to outside investors to invest equity capital.
Few entrepreneurs seeking equity investments have personal contacts with people that can offer adequate and available money. For those who don’t, one option is to engage an intermediary or “placement agent” to assist them in the process of finding potential investors. A placement agent usually refers to a person or firm that is a registered broker-dealer, but sometimes also includes “finders.”
Broker-dealers are regulated professionals or firms that have passed a series of exams and have gone through a lengthy registration process that includes interviews. Finders, on the other hand, are not generally regulated. According to federal law, a broker-dealer is “any person engaged in the business of effecting transactions in securities for the account of others.”
For purposes of this article, the key language is “in the business of effecting transactions.” A finder is someone not in “the business of effecting transactions.” Rather, finders infrequently bring investors and companies together, but that’s all they can do. By law, a finder is not permitted to pitch for the company, develop deal terms, or negotiate for or represent the investor or the company.
There are likely many finders out there who actually perform the services of a broker-dealer, but have failed to register as one because of either ignorance or the time and cost that it takes to become registered. However, it is a violation of federal and most state securities laws to fail to register if a person or firm is engaging in conduct that constitutes broker-dealer activities. A violation of one of those laws can bring fines, investment rescission, penalties, headaches, and in egregious situations, imprisonment.
Wisconsin, for example, places significant restrictions on performing any “finder-related” activities, and takes away common Blue Sky exemptions (which I will discuss in a future article) if a company compensates a finder as part of a sale of securities to a Wisconsin resident. Moreover, there are regulatory issues of giving transaction-based compensation to finders, which often times is exactly what the company and finder want to do.
Because of these and other regulatory issues and various limitations in using finders, it is usually better to work with a broker-dealer rather than a finder. However, there are many more finders that are willing to work with early-stage companies than there are broker-dealers willing to do so.
You may ask, “how does one find a placement agent?” Typically, they find you. However, if that hasn’t happened, entrepreneurs can talk with their lawyers, accountants, or other entrepreneurs about their experiences with various placement agents in their area.
When selecting a placement agent, there are many things to consider. Probably the most important consideration is trust. By using a placement agent, you are putting a lot of faith in an individual or firm. Below are some other considerations:
• Experience generally as a placement agent.
• Experience and success with companies in similar industries raising comparable amounts of money.
• Knowledge and experience with securities laws.
• For broker-dealers, good written policies and procedures.
• For finders, the impact of using a finder on state Blue Sky exemptions, and potential legal issues with using the particular finder.
• Pre-existing substantive relationships with prospective accredited investors.
Contracts with placement agents vary significantly. At the extremes, I have seen handshake deals, which I strongly advise against, and I have seen 25-page agreements. Below is a list of areas that are commonly negotiated in arrangements with placement agents:
• Compensation amount and type (e.g., retainer/monthly fee versus a transaction-based fee).
• Events that give rise to compensation.
• Additional services.
• Representations, warranties, and covenants.
• Use of affiliates to assist in process.
• Ability to terminate and effect of termination.
Once a company decides to engage a placement agent, finding the right one(s) under the right terms are essential. The placement agent may not only affect the success of your offering, but the placement agent may also affect (positively or negatively) the reputation of you and your company, expose you to securities law liability and sanctions, and bind you to a long-term, comprehensive, and expensive set of services.
So, if you decide to work with one or more placement agents, be sure to select carefully.
Other articles by Matt Storms