Hooked on Shark Tank?

August 20, 2015

We’ve all watched these investor pitch competitions. They spring up like mushrooms after rain and are loosely based on ABC’s hit show, “Shark Tank.” (Upfront disclaimer – this is not a story about that show. ABC, call off the lawyers.)

Hardly highbrow, but it’s compelling. Sweaty, nervous entrepreneur with a cool idea but no money has a minute or two to pitch the dream to a panel of moneymen and moneywomen. Thumbs up or down for the gladiator, often depending on whether he or she can actually remember any numbers at all in the heat of the pitch.

Somebody wins, often after several rounds. What the winner gets is sometimes not entirely clear but, hey, it’s a chance – fame, exposure, bragging rights, the right to claim fame for having been on TV. It might also turn into seed capital.

An investor might also make money. Statistically speaking, some of these fresh ideas should make good. Accredited investors are presumed to know the risks.

Who certainly makes money?  In gambling circles, the answer is obvious. The house always wins. That is rule number one of the game.

That’s the basic structure and those are the basic rules. However, investors and entrepreneurs, alike, need to be alert to another wrinkle.

Whenever investors, including promoters of investor pitch competitions, take an equity interest in a promising start up, it becomes a matter of state and federal securities law. Entertainment aside, violations of securities laws can have serious consequences for all involved.

Game Basics

The basic structure of a pitch competition involves three parties:

  • the entrepreneur with the great idea and zero dollars,
  • the investor looking for a healthy return on investment but who has some money to lose if the whole thing goes south, and
  • the promoter of the show who looks for revenues from the show, maybe advertising, maybe a fee or company stock from successful contestants in exchange for mentoring, advising, publicity and introductions to other potential investors.

The Accredited Investor Rule

Rule number two of the competition, since these start-ups are not publicly traded companies, is that the people who want to invest must be accredited investors.

As defined in securities regulations, this means people whose net worth, excluding the value of a residence, is greater than $1,000,000 or who have income greater than $200,000 per year or $300,000 with a spouse. Securities laws are protective of investors, and someone in this group can presumably afford to lose money in a risky start-up investment, which the ideas floated in pitch competitions certainly are.

We’re not terribly worried about accredited investors. They should know that if it’s not lunch money, they shouldn’t play. It may, however, be a source of disappointment to someone wanting to sit on the investor side of the table at a competition.

The Promoter

More serious securities issues may arise with respect to the promoter’s compensation scheme.

Except in very limited circumstances, paying a commission or “success fee” to a promoter in exchange for help in finding investors violates federal and state securities laws if the finder is not registered as a broker-dealer. Registration is a demanding process that few reality show promoters want to undertake.

The following typical contract language in the agreement between the entrepreneur and the promoter should set the entrepreneur’s and the investor’s collective hair on fire:

[Advisor] shall be entitled to receive the equity compensation at an exercise or purchase price equal to the current fair market value of the [Company’s] Common Stock.

This is especially true when the percentage of stock to which the promoter becomes entitled fluctuates depending on whether the company is considered to be in a start-up, idea or growth stage.

What are the Broker-Dealer Rules?

Most brokers and dealers must register with the SEC and join a self-regulatory organization. Without getting too deeply into the weeds of securities law, a broker is any person engaged in the business of effecting transactions in securities for the account of others. “Effecting” is the tricky word, here.

A dealer is any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise. If the same individual or corporate entity does both, there is a potential for conflict of interest.

At a very fundamental level, securities laws work on the “sunlight” principle. A broker-dealer who might be on more than one side of a deal needs to register, disclose, disclose, disclose some more and self-police.

In a competition where the promoter rewards the winner of a pitch competition with a promise of introductions to other investors and is compensated with an equity interest in the fledgling business, which might become more valuable if the investor pitch is successful, it is possible that the promoter is operating as a broker-dealer. Broker-dealers must register with the SEC as described above. It’s an onerous process and few if any reality show producers do.

The SEC Looks at the Substance of the Agreement

The Securities and Exchange Commission and state securities regulators care very little about whether the agreement executed between the entrepreneur and the promoter is described as an “Advisor Agreement” or whether it contains disclaimers that neither party intends the other to act in a fashion that would require broker-dealer registration.

Regulators look to the substance of the transaction, and have found that activities including the following have led to broker-dealer classification:

  • Negotiating the terms of a financing transaction;
  • Offering or providing advice or recommendations in the transaction;
  • Receiving fees contingent on the success of the transaction; and
  • Providing issuing companies with assistance in drafting or distributing sales and financial materials.

These are, in many cases, precisely the kinds of services that start-ups look for from promoters.

Penalties for Failure to Register

Has there been a prosecution for this kind of behavior? Not as far as we have been able to discover. However, if the SEC were to turn its attention to the pitch competition entertainment business, the penalties for violating the broker-dealer rules could be harsh, and the promoter is not the only person who gets tarred.

If the SEC finds that the promoter has been acting as an unregistered broker-dealer, it may be barred from enforcing and collecting fees. The SEC may issue cease and desist orders and impose civil penalties or even seek criminal fines or imprisonment for knowing violations.

Investors have the right to recover their investment on the basis that they were materially misled by not being informed that the finder was not a registered broker-dealer.

Companies may have to return the investment money. The company’s directors, officers and owners, may be personally liable to investors and sanctioned by regulators for violations. The start-up may be barred from future stock offerings, which tends to ruin a future that hasn’t even begun yet. Additional risks include:

  • Regulatory sanctions for employing an unregistered broker or for aiding and abetting the violation of federal/state law by the unregistered broker, including administrative fines, inability to rely on certain securities registration exemptions, and criminal penalties;
  • 10b-5 securities fraud liability to investors and regulators for failure to disclose use of an unregistered broker;
  • Loss of the securities registration exemption. Responsibility for the unregistered broker’s actions such as general solicitation (prohibited by Regulation D), and fraudulent misrepresentations by the broker;
  • Unavailability of legal opinions on legality of the issuer’s stock;
  • Loss of institutional investors’ interest in the offering; and
  • Tainted financial statements.

Even if the entrepreneur’s contract with the promoter who turns out to be an unregistered broker-dealer is void and unenforceable, the promoter can be counted on to sue. The costs and aggravation of fending off claim for fees can be substantial.

As bad as it is for investors, an unfortunate contract with a pitch competition promoter could be financially devastating to the fledgling business.

Pitch competitions can be great entertainment and probably have a little bit of educational value for those with something to sell. It would probably be too curmudgeonly to advise hopeful entrepreneurs not to play. The best advice for the unsophisticated is not to sign any agreement without legal advice.

It’s a show. In the end, reality TV is its own strange genre of fiction, like Publisher’s Clearing House prizes, the lottery and blackjack. It’s addictive fun, but as strategy for raising capital investor, pitch competitions may be a trap for the unwary. Rule number three if this game is to be wary.

Anne Wallace, Esq.


Anne Wallace is a New York lawyer who writes extensively on legal and business issues. She also teaches law and business writing at the college and professional level. Anne graduated from Fordham Law School and Wellesley College.

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