Using “Finders” to Find Capital: Avoiding Problems for Your Company

Raising money for your startup can be hard. Not every entrepreneur can walk into Silicon Valley with a business idea and walk out with multiple VC term sheets in hand. Sometimes the only path to financing your startup is through the hard work of pitching and cobbling together a group of angels and other individual investors. But that path takes time and can be frustrating. Potential investors may hesitate to commit or, even worse, give you the dreaded “you’re-too-early-for-us” response. The offer from a “finder” to introduce you to investors with cash sounds attractive. Why not, right? What’s the downside?

You can use a finder if their role is limited and their compensation is structured properly. But you can cause major problems for yourself and the finder if they’re too involved and paid commissions on the money raised. These are activities that only registered broker-dealers (persons or firms engaged in the business of buying and selling securities for themselves or others) can engage in. If your company uses a finder acting as a broker-dealer, you might find your fundraising round unraveling, and your finder might find themselves in trouble with the Securities and Exchange Commission (SEC).

A “true” finder

A “true” finder can be OK if they limit their role to making introductions, receive a flat or hourly consulting fee that is not contingent on the success of the offering, and avoid any active role in negotiating and completing the investment. Finders acting in this very limited capacity are not considered broker-dealers. As a result, true finders are largely unregulated under the securities laws and need not be registered with the state or federal government as broker-dealers. This area is murky, however, because there are not clear regulations and the rules of the road have been developed in court cases and case-by-case “no-action” letters from the SEC.

The real problem is that many finders do not limit their activities to mere introductions. These finders end up assisting in structuring and negotiating the offering, providing advice regarding the offering and investment, and even encouraging and inducing investors to invest. These activities make them a “broker” under the securities laws, and federal and state governments require that brokers be registered. Often the finder is not registered as a broker.

Finders also prefer success-based compensation, calculated as a percentage of the funds raised by the company, and companies prefer to pay finders only if and when they’re successful in helping to raise capital. Both courts and the SEC, however, take the position that such success-based compensation (also referred to as transaction-based compensation) is the telltale factor indicating whether a finder is acting as an unregistered broker-dealer.

So, what’s the risk?

For the company, using an unregistered broker-dealer to assist with an offering could create a rescission right in favor of the investors. If investors succeed in rescinding their investments, the company must return their money. For the finder acting as an unregistered broker-dealer, they could be subject to severe SEC sanctions and the company could void the finder’s engagement agreement, requiring return of the finder’s compensation. Moreover, even if a finder’s activities and compensation are perfectly legal, the relationship alone can still give rise to problems for the company. Any financial relationship with a finder must be disclosed to investors and listed on the company’s Form D filed with the SEC and state securities departments. Disclosure of such a relationship, again, even if perfectly legal, may nevertheless prompt some states to initiate an investigation.

The situation in Michigan, however, is even murkier. In the recent case Pransky v. Falcon Group, the Michigan Court of Appeals held that a “finder” as defined in the Michigan Uniform Securities Act, was not required to be registered with and regulated by the State of Michigan, even where the company agreed to pay success-based compensation. Michigan companies and finders, however, should not take the opinion as a green light to engage in a finder relationship, structured with success-based compensation, without fear of regulatory oversight. The trial court initially dismissed the case on summary judgment, and as a result there was no evidence in the record of whether or not the finder’s activities went beyond mere introductions. In addition, some commentators have criticized the court’s decision. Perhaps sensing such impending criticism, the Court of Appeals, in a footnote, cautioned that the “better course of action would be for finders acting pursuant to similar contracts to protect themselves by registering, at the very least, as broker-dealers; the line between a finder’s activities and that of a broker-dealer…is a thin one and persons acting under such contracts without being registered are inviting litigation.”

The bottom line

Using finders for raising capital is not the easy solution it appears to be at first glance. Worse yet, it can lead to significant problems. As the saying goes, nothing worth having is easy. If you don’t have a VC-backable business, you may have an even harder time raising capital than most. Regardless, when it comes to raising money for your startup, be your own “finder”. Network, hustle, and tell your story. No one is more effective than you at explaining your business and the investment opportunity.

For more legal analysis check out the National Law Review.

This post was written by Matthew W. Bower of  Varnum LLP.

What Cuba Wants From Investors

American investors have made their way into Cuba. What Cuba Wants From Investors Just this week, the U.S. Treasury Department has approved the first significant U.S. business investment in Cuba since 1959: the Oggun tractor factory. This plant represents a $5 million to $10 million investment by an American company in Cuba.

Both countries seem serious about moving their recently-resurrected commercial relationship forward. The U.S. and Cuba have entered into an agreement to resume commercial flights between the two countries the same week Cuba’s Minister of Foreign Trade and Investments, along with other officials from the Ministry of Foreign Affairs, Cuba’s Central Bank, and the Cuban Chamber of Commerce, have come to meet with the U.S. Secretary of Commerce to discuss how the two countries could further bilateral commercial relations.

While the focus of politicians’ rhetoric and scholars’ analysis has been on either what Americans are allowed to do, or on what Americans should want to do in Cuba, attention should be paid to what Cuba wants from its investors.

Cuba Wants Investors

First, there can be no doubt that Cuba wants investors.

In September 2013, Cuba created a Special Development Zone at Mariel (Zona Especial de Desarrollo Mariel). This $900 million port was formed in November 2013, 30 miles west of Havana, with the express purpose of attracting foreign investment. Many Americans are already familiar with Mariel, but remember it for the 1980 mass boatlift that carried thousands of Cuban refugees to America’s shores.  Instead of being a point of departure, Mariel is now a destination for foreign capital.

A few months after the creation of the Special Development Zone, Cuba’s National Assembly unanimously passed the Foreign Investment Act (Law 118) on March 29, 2014.  Law 118 promises foreign investors tax breaks and legal protections for their investments.

These far-reaching overtures to potential foreign investors were not made, however, without certain conditions.

Cuba Wants Investments in Particular Sectors

The Foreign Investment Act delineates, among other things, which investment vehicles are permissible, how investment shares may be transferred, who may be hired to work on the investment projects, and how disputes may be resolved.

Cuba has also specified in what it wants foreigners to invest. Last year, Cuba published a Portfolio of Opportunities for Foreign Investment detailing 326 projects in twelve sectors ripe for foreign investment:

  1. Tourism – 94 Projects

  2. Oil – 86 Projects

  3. Agriculture and Food – 40 Projects

  4. Renewable Energy – 22 Projects

  5. Industrial – 21 Projects

  6. Mining – 15 Projects

  7. Transportation – 15 Projects

  8. Construction – 14 Projects

  9. Biotechnology and Medicine – 9 Projects

  10. Business – 4 Projects

  11. Health – 3 Projects

  12. Audiovisual – 3 Projects

The highest number of projects was, not surprisingly, in the tourism sector. Cuba’s official policy on tourism investment is to direct foreign capital towards building or reconstructing new hotels and corresponding infrastructures. The President of Cuba’s Chamber of Commerce has noted the need to increase hotel capacities and standards in Havana and other heritage cities. So far, 74 hotel marketing and administration contracts have been signed, and these include almost 20 contracts with foreign firms.

Interestingly, Cuba has expressed a desire to attract foreign chains to its coasts, and is reportedly working on establishing agreements with renowned international chains across 58 facilities. Cuba is also promoting real estate development, including golf courses, marinas, and theme parks. Cuba has predicted that it will be one of the Caribbean’s top golfing destinations, and has already created two joint ventures, with British and Chinese investors, responsible for hotel construction. These projects are said to be worth over $400 million.

Furthering its efforts to attract investment in its tourism sector, Cuba is hosting its 36th International Tourism Fair (FITCUBA 2016) this year, which will be dedicated to Cuba’s culture and will feature Canada as the guest of honor.  Canada represents one of the highest sources of visitors to Cuba each year.

Notably, the Beacon Council, Miami-Dade County’s official economic development partnership, has identified seven target industries Miami’s business leaders should focus on:

  • Aviation

  • Banking and Finance

  • Creative Design

  • Hospitality and Tourism

  • Information Technology

  • Life Sciences and Healthcare

  • Trade and Logistics

The overlap between Cuba’s and Miami’s lists of target industries, along with Miami’s geographical proximity to Cuba and supply of Spanish-speaking professionals make the city an obvious key player in the development of Cuba’s business sector.

There are certain sectors, however, in which Cuba will not allow private ownership.

Cuba Does Not Want Investments in Particular Sectors

Notably, last December, Cuba’s official newspaper, the Granma, published an article titled, “Open Also Your Mind to Foreign Investment,” encouraging the Cuban people to embrace foreign investment. Cuban officials have reiterated that these changes in economic policy will not threaten the country’s socialist regime. Cuba’s policies expressly prohibit investment in sectors that may threaten Cuba’s political landscape.

For example, the Foreign Investment Act makes it illegal for a foreigner to invest in education services for Cubans and in the armed forces. Cuba’s Constitution also states that Cuba’s press, radio, television, film industry, and other mass media can never be privately owned.

These carve-outs are consistent with the Cuban government’s assurances to its people: Cuba is importing only capitalists’ capital, not their ideologies.

While it has been said that profit is apolitical, investors should not ignore the political contours of Cuba’s budding foreign investment regulations, as these may impact their investment opportunities.

Should Investors Buck the Status Quo with LLCs?

The National Law Review recently published an article by Jason B. Sims of Dinsmore & Shohl LLP regarding Investors and LLCs:

Sometimes change is good.

Too often investors and entrepreneurs just stick with the status quo, in terms of structuring a venture capital or private equity investment. One notable example is requiring that target portfolio companies formed as limited liability companies reincorporate into a “C” corporation because…well…that is just how it is always done.

Actually, the decision is a bit more thoughtful than that. One concern that investors have with LLCs is the typical pass-through tax election these entities make to provide economic benefits to the founders during the lean, loss years.That is a valid concern because funds investing in a pass-through vehicle will experience phantom losses and gains that flow to them as a result of the investment, which creates accounting nightmares. Many limited partnership or operating agreements for funds prohibit investments in pass-through vehicles for that reason.

Another reason that investors often prefer corporations, particularly in Delaware, is the generally corporation-friendly laws and the deep body of judicial opinions interpreting those laws create some level of predictability on how bad situations will play out. The laws governing LLCs and the related judicial opinions interpreting those laws are not nearly as robust in Delaware or any other state when compared to dealing with corporations.

Avoiding unnecessary tax issues and enjoying the protection of a wealth of well interpreted corporate laws are both relevant analytical points to consider, but they are not necessarily determinative of the choice of entity question.

Funds can eliminate the issue of phantom losses and gains in two ways. The most obvious is to have the LLC make an election to be taxed as a corporation. That sort of flexibility is one of many attractive features of an LLC. The other method to avoid phantom losses and gains is to set up a corporation, often referred to as a “blocker corp,” to serve as an intermediary between the fund and the LLC. This is something that private equity firms do more than traditional venture funds.

Delaware LLCs are not going to win the battle of legal precedent any time soon. But that doesn’t necessarily matter, because there is one step that the LLC can take that arguably trumps all the general predictability—at least, as far as the investors are concerned. That step, of course, is limiting, or even eliminating, fiduciary duties.

Venture capital or private equity investors often want to insert one (or more) of their own onto the boards of directors for their portfolio companies. That makes perfect sense because the investors have a vested interest in keeping abreast of the progress of their investment. The investors also typically have a wealth of experience that adds tremendous value to the development of the company, when they serve on the board. The rub is that serving on the board opens a Pandora’s Box for liability in the form of fiduciary duties.

In an earlier blog post, Mike DiSanto discussed the impact of fiduciary duties have on investor designees serving the board of directors of a portfolio when that portfolio company completes an inside round of bridge financing. But that isn’t the end of the analysis. Inside-led rounds of equity investment present the same issues, and investors wanting to truly double down on an investment shouldn’t be prevented from doing so from the fear that the valuation and other terms used to consummate the equity round will later be deemed to fall outside the inherent fairness test imposed by Delaware corporate law – remember, that standard is applied using 20/20 hindsight, making it ultra risky.

Of course, there is more. In the unfortunate event of a fire sale of a portfolio company, a board dominated by investor designees faces liability when the preferred holders consume all of the acquisition proceeds due to previously negotiated liquidation preference (full case here). Those same directors face potential liability when the board approves a reverse stock split that has ultimately forces a cash-out of minority stockholders (full case here).

There are lots of other examples, but you get the point. Fiduciary duties generally force investor designees serving on the board of a portfolio company to think about what is in the best interest of the stockholder base as a whole (or sometimes just the common holders), not what is best for the investment fund.

Delaware LLCs have a distinct advantage vis-à-vis corporations when it comes to mitigating potential damages for breaches of fiduciary duties. The Delaware Limited Liability Company Act allows for LLCs to expressly limit, or even eliminate, the fiduciary duties of managers or members by expressly stating that in the operating agreement.

Delaware takes this position because LLCs, unlike corporations, are a creature of contract. Not an organic form of entity that is regulated by well established corporate laws. Delaware has long encouraged the policy of freedom of contract, and that policy extends to the operating agreement of a LLC, even if that includes eliminating fiduciary duties.

It is also important to note that, as a creature of contract, Delaware LLCs have the freedom to establish all the various enhanced rights, preferences and privileges that typically go along with an investor acquiring preferred stock in a corporation. In fact, LLCs are often more flexible when it comes to the ability to tailor those rights into exactly what the parties want, rather than having to conform to existing corporate laws on liquidation or voting rights, for example.

All the pros combine to make Delaware LLCs a pretty attractive choice of entity from the perspective of a venture capital or private equity investor. I think it may be time for private equity funds and venture capital firms to reconsider investing directly into LLCs.

© 2012 Dinsmore & Shohl LLP.