How can a startup legitimately incentivize someone to raise money is a frequent question for start-ups, including cleantech companies. The someone can be a founder, board member, advisor, employee, or other person.
To put the question more specifically, what legal tools are available to implement a strategy of incenting startup fundraising which:
(A) does not undeservedly give away an ownership interest in the start-up to a fundraiser who doesn’t produce,
(B) but which also does not involve a “finder’s fee” which would be illegal under the securities laws unless the fundraiser is a registered representative of a broker-dealer firm licensed by the Financial Industry Regulatory Authority (FINRA), formerly the National Association of Security Dealers (NASD)?
A “finder’s fee” is any compensation to the fundraiser that is contingent upon the funding closing. Whatever term is used, whether “finders fee,” “commission,” “consulting fee,” “advisor fee,” “success-based,” “transaction-based,” or anything else, the question is whether the compensation is contingent upon the deal happening.
Whether the question is put in a simple way as at the start above, or in a complicated way as in the last paragraph which is admittedly a mouthful, it is not uncommon in the start-up world for the question to be essentially ignored. It’s been no secret that fundraising for start-ups involving “finder’s fees” goes on without the involvement of licensed broker-dealers. It’s also well-documented in a number of sources (see also here, here, and here) that this is risky business. Putting it simply (insert a strong caveat that each company dealing with these issues should seek the advice of legal counsel), a fundraising transaction involving a “finder’s fee” which is non-compliant with the securities laws runs the risk of:
• investors being able to void and rescind the deal, including demanding their money back;
• regulators fining the individuals and company involved and prohibiting them from future securities transactions; and
• the founders and company facing very uncomfortable questions from subsequent potential funders about why the rules apparently weren’t followed in the earlier round.
So after painting the above picture of doom and gloom, here is a solution that could be considered:
(1) Because “a person’s receipt of transaction-based compensation . . . is a hallmark of broker-dealer activity,” the compensation given to fundraisers who are not licensed broker-dealers must be non-contingent.
(2) Assuming the typically cash-strapped start-up does not want (and often cannot) pay non-contingent professional or consulting fees, whether fixed or hourly, then an alternative is an outright (non-contingent) grant of equity. But then isn’t the start-up granting equity ownership without any assurance that the grantee will successfully raise funds?
(3) The answer is yes, because the equity grant must be outright and not “success-based.” But that does not mean the class of equity has to be straight-out common shares or LLC membership units. Instead, consider granting class B common shares or units which under the company’s articles of incorporation and by-laws, or operating agreement, have no voting rights, no dividend or distribution rights, are last in the liquidation preference order including after employee incentive equity, and as a class have a put option which can only be exercised to receive $X if the company has a minimum of $Y cash and which must be exercised within a short period of the equity grant (say 6 months).
(4) If not exercised during the short period, the put option expires and the fundraiser continues to own outright the class B common shares or units which cannot vote, receive dividends or distributions, and are dead last in being paid. There is a chance, of course, that the fundraiser could end up getting some value from the outright grant of class B common shares or units even if his or her fundraising is unsuccessful (which is key, as explained above). But it is much more likely that if his or her fundraising is unsuccessful during the put option time period, the company will not have the cash to make that put option exercisable and without that cash, the company may well not survive. In that case, the outright grant of class B common shares including the put option to the fundraiser will probably not be among the things that the entrepreneurs in the start-up end up lamenting.
The above is food for thought, not securities law advice to you or your start-up. If you or your company are considering how to incentivize someone to raise funds in a manner that complies with the securities laws (which you should always do), seek the advice of legal counsel. As just one illustration, in addition to the above considerations, it is important to take account of whether the fundraiser is a founder, board member, advisor, employee, or other person.