The SEC has proposed new rules that would clear up the longstanding difficulty a venture capital fund manager has faced when wanting to use a “finder” for investors in the fund and such “finder” is not licensed as (or associated with a licensed) broker-dealer.  This article discusses the application of the proposed new rule to venture capital fund managers, but note that the proposed rule is impactful for managers of other types of private funds as well as private companies.

Unregistered “finders” have long been a fixture in the venture capital community, and a source of considerable regulatory uncertainty.  Based on SEC guidance dating back to the early 1990’s, a so-called “finder’s exemption” was thought to exist whereby a person could perform the limited function of introducing investors to an issuer, such as a venture capital firm raising a new fund, for compensation without registering with the SEC as a broker.  However, the SEC never formally endorsed a “finder’s exemption.”

Indeed, based on its broad interpretation of the term “broker,” the SEC has in some cases over the years denied regulatory relief to finders and even brought enforcement action against finders and the issuers that hired them.

As market practices and the SEC’s approach to finders have diverged, fund managers that want to use unregistered “finders”  have faced a difficult choice: accept the regulatory risk, insist that the “finder” associate herself with a licensed broker-dealer or simply forego the chance for increased investor introductions.  IA particular regulatory risk faced by fund issuers was resulting doubt regarding the use of Regulation D as a 1933 Act exemption for their offerings.

In response to demands from the industry over many years for additional clarity in this space, the SEC has now proposed a formal exemption from broker registration requirements for finders that meet certain conditions.  If the exemption is approved as proposed, it will provide much needed regulatory certainty for fund managers and a clear framework for how finders should be engaged.

Scope of the Proposed Exemption

The proposed exemption would permit payment of transaction-based compensation by fund managers (i.e., a percentage of sourced investors who subscribe to the fund, for example) to finders, provided the following conditions are met:

  • The finder is a natural person, and not a legal entity or fundraising platform;
  • The fund using the finder does not file reports with the SEC under the Exchange Act and is relying on an exemption from the Securities Act (such as Regulation D) to conduct a primary offering;
  • The finder does not engage in general solicitation;
  • All potential investors solicited and introduced by the finder are “accredited investors”;
  • The issuer and finder enter into a written agreement that describes the finder’s services and compensation;
  • The finder is not associated with a broker-dealer; and
  • The finder is not subject to a statutory disqualification.

These conditions align well with primary offerings of private funds that rely on the 3(c)(1) or 3(c)(7) exemptions from registration under the Investment Company Act of 1940, and are offered under Rule 506(b) of Regulation D.  We suspect that our fund clients’ typical relationships with finders will generally be able to be conducted in a manner consistent with these conditions.

Tier I and Tier II Finders

The proposed exemption covers two categories of finders:

  • Tier I finders would be permitted to provide contact information of potential investors in connection with a single capital raising transaction by the fund in a 12 month period, but would not be permitted to have any contact with a potential investor about the fund. This exemption essentially permits a finder to sell her rolodex to an issuer in exchange for success fees.
  • Tier II finders would be permitted to engage in more direct solicitation activity, including identifying and screening potential investors; distributing offering materials to the prospective investors; discussing the offering with the prospective investors (but not advising as to the valuation or advisability of investing); and arranging or participating in meetings with the prospective investors and the issuer.

Because of their greater involvement in solicitation activities, Tier II finders would be required to provide a solicitation disclosure to each prospective investor prior to or at the time of the solicitation, and obtain a written acknowledgment of receipt of that disclosure from each prospect who invests in the fund. This process closely tracks the requirements that registered investment advisers are required to follow when hiring solicitors under the “Cash Solicitation Rule”, and we expect that finders and the fund managers that hire them will be able to leverage existing industry standard forms of agreements and disclosures to meet these requirements.

What Happens Next?

The proposed exemption will soon be published in the Federal Register, which will start a 30-day comment period. The SEC staff will then gather and review the comments, and determine whether any changes to the proposal should be made. During that process and until the exemption is ultimately finalized, we unfortunately remain in the murky grey area of uncertain regulatory risk. In addition, while some may view this proposal as an expression of the SEC’s views on the regulatory treatment of finders, we note that this proposal is not yet effective and caution is still warranted when dealing with unregistered finders.


Kenneth Juster

Posted by Cooley