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.

Part Three: Tips and Considerations (#11 – 15) before Opening a Fitness Studio or Gym

This article is the third in a three part series on tips and considerations before opening a fitness studio or gym.  For the first article (Tips 1-5), please click here.  For the second article (Tips 6-10), please click here.   Here are tips 11 -15:

open sign, fitness studio, gym

11.  Promote Your Studio Cost-effectively.  Bad news: building a membership following always takes more time and effort than fitness owners would like.  Good news: social media platforms have made marketing for fitness facility easier than it has ever been.  One common theme I see among successful fitness brands and ventures that have started within the past 5-10 years is their fierce devotion to maintaining their online brand via Facebook, Twitter, Pinterest, Instagram, Yelp and other relevant social media sources.  Social media is a proven winner on announcing sales, discounts and other relevant deals for getting potential clients in the door.  Ideally, you should start creating your social media presence about 3 months prior to your grand opening.  One word of caution: be careful not to start your online presence too early – I have had friends follow brands/new gyms online for months waiting for the studio or gym to open, only to be constantly let down at the continued delays. This leads to bad feelings from prospective clients and should be avoided where possible.  

12. Carefully Weigh Your Financing Options (Debt vs. Equity).  Most owners need outside financial support when opening a gym or club facility.  This money can come in the form of equity (people who give you money in exchange for an ownership interest in your company) or debt (bank or other third party that gives you money that must be repaid with interest).  Many people opt to take debt, as they do not want to give up any ownership or control in the company.  However, in many cases, banks and other third party lenders will not lend to an entity with no historical financials.  In the near future, the Health and Fitness Blog will have a separate blog entry devoted specifically to this topic (debt vs. equity).  Another option to finance your business is to (carefully) explore equipment financing, which is discussed in Tip 14 below.  

13. Personal Guaranties (On Third Party Debt).  Many third party lenders (banks) will also require a personal guaranty.  A personal guaranty, if drafted correctly, will make the guarantor (person or people executing the document) personally liable for the company’s debts.  When possible, an owner of the company with significant personal assets should always resist signing the personal guaranty, or at the very minimum attempt to limit the total amount of the personal guaranty.  There are a variety of techniques and methods for negotiating down the scope of the guaranty depending on the lender’s appetite for risk.  

14. The “Easiest” Financing May Be the Most Costly.  Many new business owners get frustrated with the convoluted process and length of time it takes to obtain traditional bank financing, in addition to having to sign a personal guaranty (discussed in Tip 13 above).  An alternative source of financing sometimes comes from the equipment companies, which often have affiliated financing entities that lease or sell equipment to club fitness facilities.  Be aware that while it is generally easier to obtain financing from an equipment company affiliate, the penalties for non-payment may be swift and severe.  In most cases, if you miss a payment on purchased or leased equipment, the financing source will likely have the right to charge you a default interest rate of 15-20%, and after a certain period of time, the equipment will be seized from your location (without any refund for fees paid to date in the case of purchased equipment).  Be sure to read the financing agreement closely and find out the default interest rate and equipment seizure remedies, and consult with someone well-versed in finance if you are in over your head.

15. Start Small and Work Your Way Up.  Many entrepreneurs are resistant to opening their doors until everything is just right.  These owners want all the bells and whistles in their studio or club before they start getting traffic through the door.  My advice is to avoid following the mantra “go big or go home” when deciding how much equipment to initially purchase or lease, and what wish-list items you actually install in your studio or club facility before you open your doors.  From financial perspective, open machines = negative cash flows.  In the end, it is better to start small and, as your membership grows, add treadmills, ellipticals and other equipment assuming there is additional unused space.  Also, by starting small and seeing what works and what doesn’t work, you avoid giant expenditures that are big unused eyesores in your facility (double whammy).

© Horwood Marcus & Berk Chartered 2015. All Rights Reserved.

Part Two: Tips and Considerations (#6 – 10) before Opening a Fitness Studio or Gym

This article is the second in a three part series on tips and considerations before opening a fitness studio or gym.  For the first article Tips 1-5, please click here.  Without further ado, here are tips 6 – 10:

6. Location, location, location.  In my experience, poor location choice is the #1 mistake that people make when opening a fitness studio.  “Right” location consists of not only a great geographic location (i.e. high foot traffic, lots of public transportation and/or parking, ancillary businesses like Lululemon, but also the right cost per square foot.  The perfect geographic location is no longer perfect if the price per square foot is too high – especially in the first few months of operations.  Conversely, going a bit off the beaten path to secure a much cheaper cost per square foot is also crippling to a business.  You may have lower rent, but you will also have lower membership.  Working with a broker that is knowledgeable about fitness studios in the targeted area is highly recommended.  Remember, the broker is paid by the landlord, so this is virtually a free service for a prospective studio or gym owner.

7. Negotiate (do not just sign) your lease.  You have found the perfect location at a rent that works for your business model – GREAT.  The next step is the landlord (or their attorney) sending you its form Lease Agreement.  I have personally come across Lease Agreements for studios and gyms ranging from 6 pages all the way to 60 pages.  In sum, the form that is presented to you is going to be extremely one-sided in favor of the landlord and will likely need to be negotiated in a few key areas.  Some (but not all) of these key areas:

1.            Term: What is the initial term of the lease?
2.            Renewal: What are your renewal options?
3.            Rent Increases: Will the renewal terms be subject to rent increases?
4.            Condition of Space: What condition will the space be delivered in?
5.            Repairs: Who is responsible for repairs?
6.            Pass Through Expenses/Taxes: Who is responsible for these additional costs?
7.            Breach/Cure: If you breach the lease, do you get notice and time to fix?
8.            Use Provisions: Can you legally operate a gym in the space?
9.            Noise: How are noise issues and remediation options addressed in the lease?
10.          Personal Guaranty: Will the landlord require a personal guaranty?

Be sure to work with a competent attorney well-versed in leasing when reviewing and negotiating your lease.

8. Price your membership options in a way that sets your studio apart.  Get away from the mindset that you should be priced similarly with other studios in the area.  If you price like your geographic competitors (i.e. other studios charge $40-60/monthly and you price at $50/month), you are bound to get lost in the shuffle. Consumers, especially millennials, crave deals and new (disruptive) gym/studio membership pricing.  A great example of the changing dynamic of studio pricing can be seen through the business model of ClassPass, which has an easy to use app for your smartphone (more on ClassPass in Tip #10 below).  Millennials love variety and ClassPass caters to the segment of the population.  Another example is My Time Fitness in Chicago, which charges members a very low monthly fee and additional charges per daily use.  Be sure to brainstorm membership models that reward fitness and encourage members to participate in the studio or fitness community at your location.

9. Get the right kind of insurance.  Some types of insurance will be required to operate your business, while others are of the optional variety.   The hard part is determining what kinds and how much insurance to carry.  Some general categories of insurance to consider are the following:

1.            Property Insurance
2.            General Liability Insurance
3.            Crime Coverage
4.            Hired & Non-Owned Automobile
5.            Umbrella Liability Insurance
6.            Directors & Officers Liability
7.            Accident & Health Insurance
8.            Employment-related/Workers Compensation

Be sure to work with an insurance agent that is knowledgeable about the proper insurance required for the type of studio or facility you are operating.  Ask a potential insurance agent for a list of previous gym or studio clients that they have worked with, and be sure to call 1 or 2 of these clients to confirm they actually know the insurance agent and like working with him or her.

10. Run your business….like a business.  When starting a studio or a gym, it is completely natural to worry about whether or not people will actually show up and pay for a membership.  These feelings of worry often lead owners (especially first time gym and studio owners) to second guess the cost/value analysis of their membership pricing.  Owners tend to be scared of an empty gym and the message it sends to the paying members and general public, and consequently owners give away free 2 week or 1 month memberships to get people in the door.  While this is somewhat acceptable in the first month or two of operations as part of your opening marketing strategy, continuing to give away free memberships is not a sustainable business model.  Once people get something for free for an extended period of time, they often cannot bring themselves to pay for it when the free period ends.  Further, paying members will eventually leave the gym because non-paying members are taking up all of the spots in a group fitness class or on the treadmills.  Fitness Formula Clubs (FFC) in Chicago charges $20 for a daily pass; other gyms charge as much as $40/day.  People often balk at the cost to use the gym for just one day, since the monthly membership fee is generally $60-90/month.  However, when you are confident in your brand and pricing, there is no need to give things away.  To become confident in your pricing, be sure to conduct market research (i.e. talk to potential members about pricing and options).

An alternative and relatively new option for gym owners to consider is joining the ClassPass network (previously mentioned in Tip #8 above), which will increase your daily visit numbers while still being compensated for those visits.  For $79 – $99 a month (paid to ClassPass), ClassPass members get unlimited classes to dozens of studios in the ClassPass network. While ClassPass members can take as many classes per month as they would like, they can only visit the same studio up to 3 times per month. This allows potential new members to explore your gym or studio (while paying ClassPass), and if they like what they see, they may ultimately end their ClassPass membership and join your studio or gym directly.  If they do not end up joining your gym or studio, you will still receive a portion of the monthly membership proceeds from ClassPass.

© Horwood Marcus & Berk Chartered 2015. All Rights Reserved.

Tips and Considerations (#1 – 5) Before Opening a Fitness Studio or Facility

I have worked with a number of clients over the past few years in opening up their own fitness studio (franchisee or otherwise) or CrossFit affiliated gym.  This article is the first in a three part series (15 tips and considerations total) aimed at helping people that are considering taking their passion for fitness from a hobby and turning it into a career.  The items discussed below are some of the best practices that I have observed in clients that were successful in their first fitness venture.

1. Write a serious business plan.  Creating a thorough business plan is one of the best ways to really force yourself to look at the financial prospects of owning a business, and is a great way to identify weaknesses prior to committing endless time, energy and money into a venture that may not be as viable as it seemed when discussing with your friends or significant other.  In my experience, my most successful clients from day 1 of opening are those that had the most well thought out business plan because they have better identified weakness prior to opening and made the proper adjustments accordingly.  As part of any business plan, you should include a line by line budget for Years 1 through 5 of the business, including granular detail on expenses associated with operating the business.

2. Understand that everything costs more than you think.  The business plan will help you understand the initial costs (equipment, build out, etc.) and ongoing costs (payroll, rent, software, etc.) of opening and running a fitness facility.  It will also force you to think about insurance, legal, employment taxes and other costs that tend to get overlooked by business owners just starting out.  My rule of thumb is to come up with a conservative budget for Years 1 and 2 of the business, and then add 20% to the final expenses line item.  The expenses, at first, will always be higher than you expect.

3. Identify and retain your “go-to” employees/managers.  Hillary Clinton once said, “it takes a village. . . ” – surely she was not referring to owning and operating a gym, but she might as well have been.  If you are the only person that everyone looks to when things go wrong, you will quickly burn out and the studio will likely fail.  The employees need an inspirational leader, and you will most definitely lose much of your inspiration after working 70+ hour weeks for what may amount to minimum wage (at best) over the first several months of operations.  It is important that you retain at least 1 or 2 key employees that you can count on to be there from the beginning.  You must take initiative to train these key employees in every facet of the business.  While generally I do not recommend just handing out equity in the business to key employees from day 1, you may consider a Phantom Equity or Bonus Plan to incentivize your key employees to work to make the business profitable.  Many of the successful gym clients I work with have Bonus Plans in place for their key executives based on the overall profitability of the gym.

4. Find the right partners, and document your business deal.  Let me first say, if you can afford to go it alone and not have business partners, I encourage you to do so.  In my experience, gym partnerships end badly 75%+ of the time.  Inevitably, one partner thinks they are doing more than the other, and they start unilaterally taking actions that damage the relationship.  Often times, friendships spanning many years are destroyed.  Before going into business with someone, spend time discussing much more than the money each person brings to the table; spend time discussing the vision of the business, decision making, how profits will be distributed, who makes hiring decisions, who makes equipment purchasing decisions, can an owner sell his ownership in the business to another person, etc.  I find the most successful business partnership are those between owners that have complementary skill and talents, and understand where each of the partners adds the most value to the business.  There is a laundry list of issues that should be discussed and agreed up before partners go into business together.

5. Find the right lawyer – someone who is familiar with issues faced by studio and gym owners.  This tip is even more important if you have partners.  Once you decide on the business deal with your partners, each of you will need independent, legal representation to properly document your business agreement in an Operating Agreement (for LLCs) or a Shareholder Agreement (for corporations).  One of the attorneys will also need to form the LLC or the corporation which will actually operate the business.  The attorney for the business will also need to review and negotiate your lease (be careful about sound/noise provisions!), possibly review your financing arrangement, and review and negotiate your Franchise Agreement (if you are going to be a fitness franchise owner).  Ask the attorney what other studios and club facilities he or she has worked with, and consider asking for a few references before commencing work with that attorney.

© Horwood Marcus & Berk Chartered 2015. All Rights Reserved.