Does Your Company Need an Investment Banker, M&A Advisor, or Business Broker? Consider the Regulatory Implications.
As with so many things, it depends. Principally, it depends upon whether your company is publicly or privately held, management’s objective, the size of the company and/or its near term growth potential, and management’s risk tolerance for a possible securities law violation.This article attempts to clarify the widespread confusion about what these terms mean, and outlines the regulatory implications, so that company owners/executives can be best prepared to select the professional services provider to meet their needs. It is written from the perspective of a securities-licensed practitioner, with the underlying premise that regardless of how a firm or individual is described, they should be properly licensed to perform the services they provide.
The article is targeted to owners of privately held, U.S. companies not planning a public offering, as it is assumed that “C- level” executives of U.S. publicly held companies, and those wanting to sell stock to the public, will already realize that they need to contract a registered broker-dealer that is securities licensed to perform investment banking activities involving an offer, sale, exchange or issuance of the company’s securities.
Reason for the Confusion
The confusion among these terms is not surprising, especially since prior to late 2009, there was no federal statutory definition that distinguished among the three. Holders of the General Securities Representative Series 7 license, also known as the “Stockbrokers License,” and/or the Corporate Securities Limited Representative (Series 62) license previously were allowed to perform selected investment banking activity, however there was no unique securities license employing the term “investment banking” until 2009.
After the financial system collapse, investment banking activities were deemed specialized enough so that the Securities and Exchange Commission (SEC) now requires the Limited Representative – Investment Banking (Series 79) license to conduct investment banking activities.
A Primer on Terminology: Investment Bank, M&A Intermediary, M&A Advisor and Business Broker
The terms M&A Intermediary, M&A Advisor and Business Broker have no federally regulated definition, but as of 2009, “investment banking” does.
Different Advisors For Different Clients
Typically, entities called “Business Brokers” broker the sale of companies generating less than $2-3 million in revenue, whereas those who call themselves “M&A Advisors, Intermediaries or Brokers” are more likely to broker the sale or merger of larger client companies. Since investment banks seldom serve companies with less than $10-20 million of revenue – and some won’t even consider established companies below $30-50, or even $100 million – the Business and M&A Brokers play an important role in the economy, as they provide ownership transfer services for smaller businesses, typically under ~$10 million revenue.
Sometimes, the informal term “Main Street Business Broker” is used to differentiate those brokers who represent very small businesses, such as auto repair shops, restaurants and retail stores that typically sell for under ~ $1 million. Almost all of these very small transactions will be “asset sales,” though the larger the transaction, the more likely it will turn out to be a sale of stock (securities), especially if the seller of the securities (issuer of the stock) is organized as a Corporation that has not taken the “S Corporation Election” for tax treatment. This distinction between sale types is important, as securities regulations govern it.
There are two other considerations that provide a much more meaningful differentiation than business size, however:
1. The sales process the intermediary employs. The smaller the business the more likely it is to be sold like real estate on a listing service. The M&A sales process is quite different, requiring a much more active out bound sales process to known and unknown targets for whom the deal would be strategically relevant. Also, it can demand greater expertise and technical knowledge of several disciplines (corporate strategy, accounting, finance, valuation, M&A process, capital markets, negotiation, deal structuring, restructuring, taxation and law).
2. Whether the firm and individual are securities-licensed.
A client’s choice of service provider needs to be aligned with the characteristics and needs of the company. The terminology describing the firm is irrelevant, so long as the services offered by it meet the client’s needs and are regulatory compliant.
Many advisor/brokers without a securities license are highly competent, well trained and professionally qualified, especially if credentialed by a professional association. However, for most capital raising, merger, acquisition or divestiture transactions involving corporations, whether public or private, ensuring regulatory compliance means contracting someone that is securities-licensed to perform investment banking services, regardless of how they describe themselves.
There is a narrowly-defined exception though, and a possible future change in the law, as described later in the article.
With the three terms explained, the rest of this article will focus on the difference between “licensed” and “unlicensed” entities – whether called “investment bank,” “M&A advisor,” or “business broker” – as the licensing distinction is crucial, but name is not.
The Regulatory Aspect of the Term “Investment Banking” Applies to All
Federal securities law states that for an individual to perform the activities described below in points 1 and 2, they must possess the Limited Representative – Investment Banking (Series 79) license, and state laws require the Uniform Securities Agent State Law Examination License (Series 63). There are a few exceptions to these requirements, but they are very limited in scope. Individuals must be registered with and supervised by a registered Broker-Dealer.
(excerpt only – MY BOLDING for emphasis)
39984 Federal Register / Vol. 74, No. 152 / Monday, August 10, 2009 / Notices
SECURITIES AND EXCHANGE COMMISSION [Release No. 34–60424; File No. SR–FINRA–2009–049] Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Notice of Filing and Immediate Effectiveness of Proposed Rule Change To Adopt the Selection Specifications and Study Outline for the Limited Representative— Investment Banking (‘‘Series 79’’) Examination Program
…the registration category encompasses those associated persons whose activities involve:
(1) Advising on or facilitating debt or equity securities offerings through a private placement or a public offering, including but not limited to origination, underwriting, marketing, structuring, syndication, and pricing of such securities and managing the allocation and stabilization activities of such offerings, or
(2) Advising on or facilitating mergers and acquisitions, tender offers, financial restructurings, asset sales, divestitures or other corporate reorganizations or business combination transactions, including but not limited to rendering a fairness, solvency or similar opinion.
Even transactions involving what may not appear to be securities, such as those involving leasing arrangements or promissory notes, may be securities, and thus regulated under federal or state law.
Only a very few of those who refer to themselves as “business brokers” hold this license; a few more would who call themselves “M&A Intermediaries” or “M&A Advisors”, but in either case, it’s a minority.
Why Some Brokers/Advisors Choose Not to Register as a Licensed Entity
It is arduous to do so. The five hour examination may take months of preparation, depending upon prior experience. The required knowledge of arcane securities law detail is onerous.
The regulatory oversight and legal responsibility is daunting. The record keeping and reporting responsibility is difficult for smaller companies to manage. The self-regulatory association (FINRA) scrutiny of the firm and all its associated individuals is unrelenting and intrusive. To weed out or catch anyone perpetrating fraud or other crimes, finger prints, permanent retention of all company emails, ongoing copies of personal stock trading activity, and background checks are required.
Choosing not to register is a rational choice, however, it requires the individual and his or her firm (and to some degree its clients) to shoulder more risk of regulatory non-compliance, and/or to accept the work limitation constraints on an unregistered, but law-abiding, firm.
People invest effort, time and money to become securities-registered. That hurdle attempts to protect the integrity of the capital markets and the interests of clients. Obtaining the license requires demonstrating a broad knowledge base that may directly benefit clients by the presentation of numerous capital raising and/or ownership transfer options, in addition to knowledge of accounting, finance, and securities law.
However, this investment also at least partly explains why it is difficult for established small businesses, usually those generating under $10 million in annual revenue, to find a securities-licensed individual and/or firm to work with them. The firms’ and individuals’ investment of capital, time and effort discourages transactions that are too small to justify the lower potential reward and much higher risk of the transaction never closing.
Pending Legislation
For this reason, some firms have avoided registration in hopes that Congress will grant regulatory relief to brokers and advisory firms offering limited services to small companies. Though various types of amendments to the Securities Exchange Act of 1934 have been advocated for years to clarify securities law applicable to business brokers, it now exists as a pending bill in Congress: H.R.2274 – Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act of 2013.
As written, this bill mostly waives the regulatory requirement for investment banking licensure to broker privately held company change of ownership transactions. “M&A Brokers” performing services in connection with the transfer of ownership for client companies under $250 million in gross revenue and/or $25 million in earnings before interest, taxes, depreciation and amortization (ebitda) would be allowed to register with the Securities and Exchange Commission (SEC) by filing an electronic notice, thus bypassing any examination requirement or qualification, unless otherwise disqualified, such as by having a criminal history.
The proposed exemption applies to M&A activity, but not advising on or facilitating debt or equity securities offerings, separate from an M&A transaction.
When the SEC and Financial Industry Regulatory Authority (FINRA) created the Series 79 Limited Representative – Investment Banking license, it was with the intent of protecting investors by establishing uniform qualifications to perform the associated activity. There is no such regulatory filter in this proposed legislation for currently unlicensed entities operating as M&A Advisors, Intermediaries or Business Brokers, as H.R. 2274 as currently written lacks a meaningful mechanism to ensure uniformity of skills for advisors serving lower middle market companies.
As written, this bill lowers the barrier to offering M&A advisory services, such that just about anyone can do so.
Furthermore, the business size description in the H.R. 2274 bill effectively means that the Investment Banking licensure requirement would be eliminated for anyone – regardless of knowledge or qualification – who advises 99.9% of the six million U.S. employer firms on issues pertaining to transfer of ownership through M&A activity (while the bill does not apply to public companies, they comprise less than 1% of employer firms, so barely influence the percentage).
Will the SEC and FINRA feel that their efforts to improve investor protection by establishing the Series 79 Investment Banking license after the financial collapse be subverted by this proposed legislation? I suspect so.
There is no certainty of H.R. 2274 being signed into law without amendment. This article focuses on the current state of the law.
Advantages of Working With A Securities-Registered Firm
Being a registered Broker-Dealer licensed to perform “investment banking” activities allows an advisor to offer a wider array of services to client companies – with reduced risk to the client.
- Licensing enables raising equity and debt capital, advising on and executing virtually all sale, merger, or joint venture with equity transfer transactions, Employee Stock Ownership Plans (ESOPs), and providing Fairness Opinions on the value of the company’s stock to its shareholders
- There are explicit federal and state law prohibitions against fraud that apply to Broker-Dealers, whereas non-registered entities do not receive the same scrutiny
- Securities-registered firms do not necessarily charge more – the market rate for fees is comparable, as it is mostly a % of transaction value. Typically, the larger the transaction size, the smaller the % tends to be, regardless of whether the advisor is securities-licensed.
- Clients have the full array of purchase, sale, issuance or exchange of securities options available to them, without restrictions, as all are legally OK. There are no false incentives for an intermediary to steer the client or deal toward a particular outcome to ensure regulatory compliance.
Increased Risk Associated With Unlicensed Entities
While an entity may describe itself as it chooses, federal and states’ securities law is very clear on what cannot be done in the absence of a proper securities license, and “unlicensed” entities performing the activities described in the regulation creating the Limited Representative – Investment Banking (Series 79) license shoulder greater risk and may share it with clients. In finance, risk is generally defined as the uncertainty of future outcomes, and in this case the uncertainty pertains to the transaction process and possible post-transaction problems.
While I do not suggest that the following risks are likely to occur, they exist, and are thus worth considering.
Transaction Risk
Unlicensed firms using the terms “investment bank” or “merger” in their marketing are more likely to attract regulatory scrutiny than in the past. In fact, select states’ securities law enforcement divisions have increasingly scrutinized firms and individuals who use the term in recent years, to ensure that they’re properly licensed to perform the associated activities.
While this scrutiny may not appear to be an issue to your company as the client, it may be problematic after all, if the firm is distracted by the regulators, or told to cease and desist performing activities pertinent to your company’s negotiations or transaction. While this circumstance is unlikely to occur, it would be very disruptive to deal activity and could easily end discussions with a given financing source, acquirer or acquisition target if it did.
Pricing risk
Investors demand a higher return for a riskier investment, and thus a lower price to be paid.
A savvy buyer or investor will discount an offer price for higher perceived risk of any sort, and the moment that an investor fears transaction or regulatory risk they may back away altogether or discount the offer (even if only used as a negotiation ploy when the risk is actually remote).
Rescission Risk
Unlicensed activity may expose both your company as “the issuer” of the securities, and an unlicensed agent, to civil liabilities. If the transaction occurs in California, the buyer may have the right to rescind the transaction for up to 5 years after it closes, per state law (see California information at the conclusion of the article). (1) Potential statutory rescission risk applies outside California, also.
Shareholder Liability Risk
Company directors may be at risk of shareholder claims that a violation of their fiduciary responsibility to shareholders occurred by not fulfilling “Duty of Care” Financial Management Obligations, to ensure that the corporation’s interest is properly represented (i.e. by a licensed entity). This issue is more likely to occur with publicly traded companies.
Generally, recision and shareholder liability problems occur well after the transaction closes when one of the parties is dissatisfied with an outcome, and seeks redress.
Selling Stock Is Usually Prohibited for Unregistered Entities
Importantly, the sale or exchange of company stock by an intermediary usually requires proper securities licensing.<lt;span style=”mso-spacerun: yes;”> This rule does not apply to a company issuing its own stock (“the issuer”). There are limited conditions in which unlicensed firms or individuals acting as an agent can sell a company’s stock, and by operating in a legal grey zone, supported by a Securities and Exchange Commission (SEC) “CBI No Action Letter,” a statement of SEC Staff’s lack of intent to recommend enforcement to the Commission, if the highly constrained conditions are met.
That No Action Letter closes with the admonition that the letter is not a definitive release from Federal securities liability (the SEC cannot guarantee that it will not take action). (2)
Prohibited Activities For Unlicensed Individuals or Firms to Advise on or Facilitate (Per Investment Banking Series 79 Points 1 & 2 Above and The No Action Letter):
- Promoting the sale of securities, e.g. the company’s stock; and one cannot even promote that “this must be a stock sale” for any reason. Unlicensed entities must promote only the sale of a company’s assets, and if the transaction later turns into a stock sale – a frequent occurrence – the intermediary must adhere tightly to the constraints of that No Action letter (must be 100% of the equity, among other conditions).
- Transaction involves an exchange or issuance of stock or other securities in a merger
- Transaction involves an exchange or issuance of stock or other securities for assets
- Representing the sale of a partial (minority or majority) equity interest in a company
- Portion of transaction consideration being paid in acquirer’s stock
- Advising either party in the transaction whether to issue securities (stock), effect the transaction by means of securities, or assess the value of securities sold
- Leading the negotiation process of a stock sale – unlicensed entities aren’t allowed to do this, and must play a limited role (some interpret this to mean document transmittal only)
- Transaction involves the sale of stock to an Employee Stock Ownership Plan (ESOP)
- Transactions involving an earn-out or seller’s note may be prohibited (circumstantial)
- Capital raising (debt and/or equity) on behalf of another
- Assembling investment entities to acquire company stock
- Arranging buyers’ financing – licensed firms can take a more active role than mere uncompensated referral introductions
- Selling equity interest to more than one purchaser entity, or group of purchasers
- The No Action letter constrains unlicensed entities to working only with “Small Businesses,” as defined by the Small Business Administration (SBA)
Problems Created By These Constraints
Clients often do not know what they need from an advisor initially, and it is through the process of transaction planning, then negotiation with the other party, that the optimal deal structure becomes apparent. As a transaction unfolds, it can turn easily during the point of negotiation from an intended asset sale to a stock sale.
The effect is that the unlicensed intermediary could be forced by the dynamics of the deal into either regulatory non-compliance, the highly constrained terms of the No Action Letter, and/or employing a transaction structure which may or may not be best for the deal or parties to it.
Beware “Consulting or Finders Fees” – The Compensation Mechanism Is Important, But Not Determinative
The Securities and Exchange Commission (SEC) says that a “broker” is any person engaged in the business of effecting transactions in securities for the account of others, and a “professional who brings together potential buyers and sellers and advises the parties on questions of value, plays an integral role in negotiating the transaction, or provides other services designed to facilitate the transaction, may be deemed to be a broker,” under the Securities Act of 1933 Section 15 (a) registration requirements.
Receipt of “at-risk,” transaction-based compensation (such as a commission or “success fee”), as opposed to a fixed fee regardless of whether the transaction closes, is one of the key factors in determining who is a “broker.” (3) Relevant case law and SEC “no-action” letters recognize that success-based compensation is a primary characteristic of the broker-dealer role.
Some intermediaries will attempt to avoid securities registration by calling themselves “finders” and/or “consultants,” while working for consulting fees, instead of at-risk compensation like success fees. Aside from the fact that the arrangement may not be cost-effective for the client company, there is no guarantee that the gambit will be a successful evasion of the requirement to register for other reasons (though it would reduce risk). Despite the lack of success-based compensation, the duties performed generally require registration, unless the intermediary’s role is limited strictly to making introductions (and even that possible exclusion is only supported by SEC No Action Letters and state case law, not federal statutory law).
The market-normal, competitive fee arrangement is for the vast majority of the compensation to be contingent upon the close of a transaction, with a modest initial retainer fee to cover a portion of the up-front costs and work.
How to Determine Whether a Firm is Securities-Licensed
Often, as in our case, the firm’s promotional materials will display something similar to the term “Member FINRA/SIPC,” though it may be small and obscured. However, not all firms associated with a registered Broker-Dealer display this. If not, it is always appropriate to ask, and to refer to the FINRABrokerCheck® link to search the database of securities-licensed firms or individuals.
Real Estate License Credentials – Do They Matter?
Some states require a real estate license to transact the sale of a business, but fewer than 20 do, and most waive that requirement for securities licensed broker-dealers and/or transactions that do not involve the sale of land. This issue is governed exclusively by state law, not federal, and is highly variable.
California requires a real estate broker’s license to transact the sale of a business, but waives it for those with securities licenses. There remains ambiguity about the limits of a CA-licensed real estate broker’s authority, however. According to an attorney’s article posted online, “a licensed real estate broker should be able to legally participate in business acquisitions and dispositions structured as either sales of all outstanding securities of a business or as sales of all or substantially all of the assets of a business, but there is some doubt as to whether a real estate broker may legally participate in a sale of a business effected through a merger, consolidation or other form of reorganization.” (4) (my emphasis)
Even where required, a real estate license’s value as a qualification to represent the sale of a business is negligible, since the knowledge required to sell a home has little in common with the sale of a business.
Other Credentials to Seek If Considering Entities Without a Securities License
There are professional associations which offer classes and credentialing tests to ensure that there is a uniform knowledge base applicable to most transactions which small, privately held companies would likely encounter. Relevant credentials would include the Certified Business Intermediary (CBI) offered by the International Business Brokers Association (IBBA), the Merger & Acquisition Master Intermediary (M&AMI) offered by the M&A Source and the Certified Merger & Acquisition Advisor (CM&AA) offered by the Alliance of Merger & Acquisition Advisors (AMAA). A few states’ professional associations have established a credentialing process, too, often in conjunction with the IBBA.
Summary
The following table attempts to summarize some key differences among the service providers. Of course, these are sweeping generalizations, presented without consideration of individual states’ securities or real estate laws, and it is strongly recommended that you consult an attorney practicing in your state who specializes in securities law for counsel. In fact, nothing in this article should be construed as legal advice in any manner.
Private company owners/shareholders who contemplate raising capital, seeking investors, succession planning, exiting a business, merging with or acquiring another company, or any other form of liquidity or capitalization event, are utilizing the asset comprising probably the largest portion of their personal net worth: the value of the business.
Advisor choice is important to ensure that the process will be strategically appropriate to shareholders’ needs and company context, optimally executed, and regulatory compliant.
If your company can get a securities-licensed practitioner to support you, why not do so? There is no reason to take on the risk otherwise.
Client Company |
Securities Registered Entity |
M&A Advisor/Intermediary Without Securities Licenses |
Business Broker Without Securities Licenses |
Is Publicly Traded |
X |
||
Is Privately Held |
X |
X |
X |
Earns Annual Revenue |
Usually over $10-20 million, with exceptions |
Usually $5-15 million |
Usually under $2-3 million |
Has more complex needs, such as patents, foreign operations |
X |
X – maybe, depending upon firm or individuals |
|
Needs to raise capital (debt and/or equity) |
X |
X – With restrictions on how accomplished |
X – With restrictions on how accomplished |
Purely An Asset Sale Not Involving Any Securities |
X |
X – With restrictions on payment consideration |
X – With restrictions on payment consideration |
Intent to Sell Portion But Retain Partial Ownership |
X |
X – With restrictions on how accomplished |
X – With restrictions on how accomplished |
Transaction Involves Valuation of Securities |
X |
||
Transaction Involves Exchange or Transfer of Securities |
X |
X – Narrow allowance for 100% of securities under No-Action Letter |
X – Narrow allowance for 100% of securities under No-Action Letter |
Transaction Involves a Note, e.g. Seller Financing |
X |
X – Non-Transferable, 9 month duration restriction (becomes a security) |
X – Non-Transferable, 9 month duration restriction (becomes a security) |
Needs to Find Buyers or Sellers of Businesses, Where Securities are Involved |
X |
Reference Notes:
Various law firms have posted online articles pertaining to California Securities Law. My links to these articles in no way implies that these law firms have endorsed this blog article, and in fact, I have not contacted either firm.
· 1) San Francisco law firm Niesar & Vestal has posted a usefulsummary of California’s Assembly Bill No. 2167 law, which says (EXCERPTS, MY BOLDING for emphasis): A person who purchases a security from or sells a security to a broker-dealer that is required to be licensed and has not…may bring an action for rescission of the sale or purchase. There are other cases outside California that have resulted in recision and/or disgorgement of fees, too.
· 4) Attorney Michael J. DiBiase, Partner at Hill, Farrer & Burrill LLP in Los Angeles, California, has posted a very clear article on Californiareal estate vs. securities law.
· The Law Office of D. Joshua Staub has published a useful article on general issues pertaining to Federal and California securities law.
McGavock Dickinson (Dick) Bransford is a Managing Director in San Francisco with Mid-Market Securities, LLC, an investment bank headquartered at 11 East 44th Street, 19th Floor, New York, New York 10017. Member FINRA/SIPC.
He can be contacted at (415) 294-0002 or mdb@mid-marketsecurities.com.
Disclaimer: This article provides general information, and is not intended to constitute, and should not be construed as, legal, tax, accounting or business advice, nor does it constitute an offer to sell or to purchase securities. Rather, it is summary compilation of timely issues confronting your industry and as such does not purport to be a full recitation of the matters presented. Prior to acting upon any information set forth in this article or related to this article, you should consult independent counsel and/or more detail contained in the Source Information. The article reflects the opinion of the writer, and does not necessarily reflect the opinions of Mid-Market Securities, LLC, or its affiliates. IRS Circular 230 Disclosure: In order to comply with requirements imposed by the Internal Revenue Service, we inform you that any U.S. tax discussion contained in this communication is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
