In general, from the board perspective, my preference is to let the CEO and outside counsel sort out any SEC compliance issues. There are two kinds of problems that pop up over and over again: first, questions about whether the company can pay a finder’s fee in connection with introductions; and second, what the company is supposed to do with folks whose accredited investor status is in question.
On both of these issues, my experience and education has made me overqualified as a director to manage these particular risks. So, if there’s internal debate or fuzziness from outside counsel, I will add thoughts based on my own experience to help frame the issues.
The short answer is that it usually violates the securities laws to pay someone 5% of the money that is invested by someone they introduce. (Plus, that's too much for a mere introduction in any case.) Registered broker-dealers, i.e., investment banks, are permitted to charge a percentage (which the SEC calls “transaction-based consideration”).
This rule applies to directors, officers, and employees. You can’t pay the new CEO a percentage of the money they bring in in the next funding round. You might give them a flat-dollar bonus based on the milestone of closing at least $X, but that’s as close as you should even think about getting to that line. Even that approach will break if you try to get cute: $50k for $5m round, $100k for a $10m round, and so on. The SEC will not be amused.
Yes, lots of people violate this law, and the SEC rarely imposes sanctions or brings cases unless there’s also fraud involved. But an unhappy investor is certainly capable of bringing a fraud claim. Do you want to put your personal assets at risk? Do you want to gamble with a losing case on a federal crime? I don’t, and I think most people shouldn’t either.
Accredited Investor Status
The SEC has created a number of regulations that provide safe harbors for certain non-public securities offerings to help channel folks toward good behavior that is intended to minimize the risks of fraud or of unknowing investment by the general public.
The accredited investor test is a cornerstone of this regulatory scheme. Many people think that the rule prohibits people who don’t meet the income or net worth tests from investing in private companies. That’s not true, and even people who should know better repeat it.
What the regulations do say to a company is that if you want to sell securities to accredited investors, there are generally no specific disclosure requirements: those folks are presumed to be able to look out for their own interests or to obtain learned advice from a third party to protect their interests.
If you want to sell to people who aren’t accredited investors, you have two options: Reg CF (for crowdfunding) which is relatively new, or make an awful lot of disclosures.
Companies could all raise money from the general public. But they uniformly reject the cost of those disclosures and don’t do it.
So, this background sets up the potential problem. If an investor is not sure if they’re an accredited investor, the company and its lawyers should generally avoid getting too close to that question. Provide resources and links to the SEC’s pages on the topic, but you generally want to stay out of the middle of it because a mistake just creates the potential for many headaches.
What I’ve seen companies do it harness a process that was added to Reg 506(c) to facilitate general solicitations, meaning letting a wide range of people know you’re trying to raise money. Before the revisions, goofing up this process led to a long quiet period, where the company would hopefully get everyone to forget its announcement, and then it would discuss financing only with specific persons with whom there was some kind of pre-existing relationship.
Now, 506(c) allows a company to make those kinds of broad announcements if it also takes “reasonable steps to verify” that each investor is in fact accredited. Essentially, this is more than what is required for a company not making the broad announcement.
So, a company that has a prospective investor who doesn’t know if they’re accredited can instead avoid getting entangled in that question or even trying to sort through the risks. Send the investor to one of the third-party verification services that sprang up after 506(c) was introduced. I haven’t used any of these, so here are just the first three I found doing a search:
- https://www.earlyiq.com/accredited-investor-certificate ($69)
- https://app.accredited.am/ (they pitch you deals)
- https://www.verifyinvestor.com/ ($59-$69)
Have the investor go figure it out and give you proof. Cheap insurance, no messy personal data flowing into your systems, and you’ve avoided giving anyone bad (or unintentionally biased) advice.
These aren’t the only ways of handling these two issues, but as a board member, you have a duty to know about these risks and to help the company mitigate these risks or avoid them entirely.