Why You Should Avoid Finders

It may be tempting to retain a broker for your next round of venture capital financing, but doing so might damage your chances

When looking to raise a Series A round of venture capital, it's common for entrepreneurs to attend networking mixers. You'll probably find a couple of venture capitalists, and I recommend you engage them. But there are likely to be many more finders (also known as brokers or placement agents).

If you talk to them, I'm sure they'll quickly make an appealing pitch. The finder will mention that his or her golden Rolodex is full of top-tier venture capitalists and high-net-worth individuals. In fact, there will be no upfront fee. Instead, compensation will be based on a percentage of the amount raised, which is called a "success fee." This can range from 1% to 10% or so.

Even though this is tempting, be cautious. You could actually be making things worse for your financing efforts.

Finders' Limitations

First, unless the finder engages in limited activities, there may be violations of federal and state securities laws. For example, financial intermediaries must register with the Securities & Exchange Commission as broker-dealers to raise capital for clients. This involves extensive filings, fees, examinations, and audits.

So what can a finder do? Simply put, the role should be to make introductions. This means it's advisable for a finder to avoid working on presentation materials, talking about the merits of the investment, or engaging in negotiations. Finders can sometimes make misrepresentations or even fraudulent statements, which can imperil a company.

Something else: The securities regulators do not want finders to receive success fees.

True, it's probably a good bet that the government will not crack down on your financing, but the risk is there. If you become enmeshed in a regulatory investigation, the legal bills could become enormous. A probe also could result in fines, cease-and-desist orders, and even a rescission right, which means investors can get their money back (with interest).

VC Are Wary

Moreover, if a finder links you with a qualified venture capitalist, the fee will likely be in the form of equity, which will probably dilute the ownership of the founders. Simply put, VCs do not want their investment dollars to go into someone else's hands (especially to finders).

So it should be no surprise that VCs are wary of dealing with finders. Peter Rip, who is a VC at Crosslink Capital, says a finder sends a clear negative signal: It's equivalent to sending a business plan via e-mail to a VC's Web site.

How about using an investment banker? While there won't be any regulatory issues, the problem remains that investment banks focus on later rounds (Series D and E, for example), and as a result, larger amounts ($20 million or more). Moreover, they usually charge large retainers, which can run $25,000 or more per month (and yes, there are also success fees).

O.K., so what can an entrepreneur do to get some help? Well, there is an alternative to finders. Keep in mind that VCs look for deal flow from trusted people, not hired guns. Such connections may be retired executives, entrepreneurs, and even other venture capitalists.

Build Relationships

To this end, you can establish an advisory board (BusinessWeek.com, 2/1/07), normally compensated at a fraction of what a board of directors is paid, which you can use as a way to build relationships with key people in your industry.

Make it clear to your network that you are in the process of raising capital and that you need some warm introductions to qualified VCs)(BusinessWeek.com, 7/14/08). Again, limit these to only introductions. For the most part, VCs want to hear the pitch from the founders.

Jason Green, who is the founder and general partner at Emergence Capital, told me that advisory board members are a key source of deal flow—and that the highest-quality ones are former executives of companies Green has funded.

To incentivize your advisory board, you should obviously provide some form of compensation. This is usually done using stock options. A typical approach is to make a grant that vests over a four- or five-year period. Furthermore, the equity amount ranges from 0.25% to 2% (depending on the stature of the board member).

Finally, you should also consider your angel investors, who might be active in the VC community (and certainly have a vested interest in getting more capital). Consider the example of Sam Blackman, who is the CEO of Elemental Technologies. One of his angel investors made an initial contact to Voyager Capital, which ultimately led to the firm co-leading a $7.1 million Series A round.

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