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What are investment banks/broker-dealers and how can they help me find capital for my cannabis startup?

Wrazel Blog Nicolas Arkells

Founders often struggle with the time commitment required to directly pursue capital sources. Determining when and if you will need to engage investment banks will largely depend on your Capital Raising Strategy.

Many startups and rapidly growing companies often do not have the resources to directly champion capital raises. Due to these constraints you may find it advantageous to engage third parties (people outside of your company) to essentially act as sales teams for your investment opportunity. 

One of the most common sources people turn to when looking for assistance with their capital raises are broker-dealers who may be investment banks or individual registered representatives reporting to a licensed broker-dealer sometimes called a “BD."

It is important to understand that although the term “bank” is used in the name investment bank they do not directly deploy any capital into your opportunity. They raise capital for your opportunity from third parties and may help with deal structuring. 

While there are many variations of fee structures, broker-dealers usually require some sort of upfront fee for due diligence (an investigation into your investment opportunity and its founders). Sometimes for larger deals they may also charge a monthly retainer fee.

They will almost always charge a fee on the percentage of capital they bring to an opportunity known as a “success fee”. For example, a 7.5% success fee means that for every $100,000 dollars an investor sourced by them brings they will be paid $7,500 and you will get the remaining $92,500.

Sometimes they will structure their success fees in a way where the percentage taken decreases as more capital is raised.  For example, it might be 10% on the first million, then only 6% on the next $2 million and then 4% on the next $5 million etc. The success fee percentage is important to factor into your capital raising strategy because it means you will need to raise a little more than originally anticipated to compensate the broker-dealers. 

When negotiating success fee amounts with a broker-dealer beware they should not be charging a total aggregate of success fees in excess of 10%. The industry average is usually 7.5% or less depending on the amount of capital being raised and the expected difficulty. If you are an early stage venture with little or no revenue you should not be surprised if they insist upon charging the legal maximum. 

Please be aware that in order to be able to charge a success fee broker-dealers must be licensed and registered with the SEC (Securities & Exchange Commission) and FINRA (Financial Industry Regulatory Authority). You should always conduct due diligence on your intended broker-dealer to make sure they are trustworthy.

At a minimum you should verify their license is in good standing through https://brokercheck.finra.org/. You should also ask to contact some of their previous clients to verify their credibility especially if you’re paying an upfront fee. 

When negotiating with your intended broker-dealer it is very important to avoid an exclusivity agreement (an arrangement that makes them the only person who can bring you capital). If the broker-dealer insists on exclusivity it should only be for a short period of time (between 90 to 180 days) unless the raise is over $20 million.

If your investment opportunity’s documents are well prepared, a credible broker dealer should not need more time than this for a smaller raise. Further, before agreeing to exclusivity be sure to carefully vet and speak with the broker-dealer’s prior clients, if the broker-dealer has an issue with this level of vetting refuse to sign an exclusivity agreement. Also, if a broker-dealer has no track record of raising capital in your industry you should not agree to exclusivity.   

For smaller raises an independent registered representative sometimes called a BD may be a viable resource. They have a wide degree of autonomy because they hang their license with a larger “broker-dealer” who provides the compliance resources needed. Unlike investment banks, they are typically a small team or just one person who is willing to sell an investment opportunity. They are generally willing to look at opportunities that may not have as much documentation as what is required by most investment banks. They are generally more flexible when negotiating deal terms.

One of the main disadvantages of an independent registered representative is that due to minimal supervision and the smaller team size they generally take longer to close an investment round. This is because they usually tend to work with retail investors more often than institutional capital sources. 

Investment banks generally have larger teams and greater institutional funding resources. For these reasons they can generally closer larger rounds much faster than independent registered representatives. However, they usually don’t get involved in a capital raise until the Series A round or later. They tend to avoid earlier rounds because it is generally not economical for them to go after raises under $5 million dollars unless they have contacts who are retail investors. They also tend to avoid earlier ventures because of the financial risk to institutional investors. It is especially concerning for them because many successful investment banks rely on reoccurring deals with similar capital resources. Expect an investment bank to ask for many documents on your opportunity before agreeing to undertake the engagement. They also tend to have very strict rules on what opportunities are accepted and how the deal will be structured.     

In short, investment banks are generally helpful resources when outside help is needed to raise capital. If an investment bank is not a viable option, smaller independent registered representatives may be a solution. Always be careful about exclusivity agreements. Most importantly do your due diligence to assess the credibility of your intended investment bank or independent registered representative.

Author Nicolas Arkells




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