The Securities Acts of ’33 and ’34 established some interesting dynamics in the financing of private equity investments. At one end of the spectrum, we have funds (venture capital, buyout, distressed asset, mezzanine, and many variants). These are usually established as limited partnerships; restricted to at least accredited investors (individuals and/or institutions); and operate on a combination of management fees and carried interest. To date, funds have to date been mostly unregulated: the assumption being that if appropriate disclosures are made to a limited class of investors at inception, investors and fund management agree on terms, and the fund managers don’t run off to Brazil with the investor’s money, then everybody’s done their bit.
At the other end of the spectrum are transaction agents: variously called brokers, dealers, merchant and investment banks. These entities don’t typically manage money; instead they bring together investors and opportunities for a fee. Fee structures range from fixed amounts for capital formation advisory services and retainers, to a percentage of the capital raised. These organizations are very highly regulated: requiring testing and certification of the professionals; registration of the firms with an industry self-regulatory organization such as FINRA; indemnification and capitalization minimums; audits and other compliance measures. Not surprisingly, engaging an investment bank to raise startup capital can be prohibitively expensive.
Somewhere in the wilderness between these two are “finders”: consultants, advisors, networkers and others who bring together investors and entrepreneurs for something in return. The securities industry has a less flattering name for these folks: “unregistered broker/dealers”, implying a level of sophistication that is usually absent. Instead, finders are often primarily engaged in some other business, but on occasion take remuneration for connection-making. Sometimes that remuneration is cash, sometimes equity. Irrespective, the law (sorta) says that if you want to be compensated for raising money for someone else, you have to be a registered broker or dealer. If found guilty of impropriety, the finder is not only subject to individual penalties (fines and presumably incarceration), but the transactions they have been involved with are forever tainted, and can trigger exercise of investor rights all the way through to an IPO.
I’m fine with establishing a level playing field for private equity fundraising, but the current situation falls way short. The reason is simple: finders aren’t strictly policed, and as anyone who has been around private equity for a while can tell you, the rules aren’t very clear. Granted, the SEC is pretty busy with nuisances like Madoff, Stanford and Rajaratnam, but the lack of clarity in legislation means very uneven enforcement, often based on the priorities of regional SEC investigators. Finders who fall potentially under this restriction, then, never know if they have ridden into Dodge City, or Tombstone.
So why should angels care? Theoretically, organized angel groups fall under this classification if they collect fees from any of the parties directly involved in the transactions: i.e., the investors and the companies. Practically, this has been enforced only in the case of success-based fees, no matter which party bears the cost (investor or entrepreneur), and regardless of whether the fee is flat or a percentage of the raise. This leaves the professionally managed angel group with limited options for revenue (hence, sustainability), and takes away the potential to align the interests of parties to the transaction from the outset. I’ll look at the implications in the next post.