Using A SAFE In Reg CF Offerings

The SEC once wanted to prohibit the Simple Agreement for Future Equity, or SAFE, in Reg CF offerings. After a minor uproar the SEC changed its mind, and SAFEs are now used frequently. I think prohibiting SAFEs would be a mistake. Nevertheless, funding portals, issuers, and investors should think twice about using (or buying) a SAFE in a given offering.

Some have argued that SAFEs are too complicated for Reg CF investors. That’s both patronizing and wrong, in my opinion. Between a SAFE on one hand and common stock on the other, the common stock really is the more difficult concept. As long as you tell investors what they’re getting – especially that SAFEs have no “due date” – I think you’re fine.

The reason to think twice is not that SAFEs are complicated but that a SAFE might not be the right tool for the job. You wouldn’t use a hammer to shovel snow, and you shouldn’t use a SAFE in circumstances for which it wasn’t designed.

The SAFE was designed as the first stop on the Silicon Valley assembly line. First comes the SAFE, then the Series A, then the Series B, and eventually the IPO or other exit. Like other parts on the assembly line, the SAFE was designed to minimize friction and increase volume. And it works great for that purpose.

But the Silicon Valley ecosystem is very unusual, not representative of the broader private capital market. These are a few of its critical features:

  • Silicon Valley is an old boys’ network in the sense that it operates largely on trust, not legal documents. Investors don’t sue founders or other investors for fear of being frozen out of future deals, and founders don’t sue anybody for fear their next startup won’t get funded. Theranos and the lawsuits it spawned were the exceptions that prove the rule.
  • The Silicon Valley ecosystem focuses on only one kind of company: the kind that will grow very quickly, gobbling up capital, then be sold.
  • Those adding the SAFE at the front end of the assembly line know the people adding the Series A and Series B toward the back end of the assembly line — in fact, they might be the same people. And using standardized documents like those offered by the National Venture Capital Association ensures most deals will look the same. Thus, while SAFE investors in Silicon Valley don’t know exactly what they’ll end up with, they have a good idea.

The point is that SAFEs don’t exist in a vacuum. They were created to serve a particular purpose in a particular ecosystem. To name just a couple obvious examples, a company that won’t need to raise more money or a company that plans to stay private indefinitely probably wouldn’t be good candidates for a SAFE. If it’s snowing outside, don’t reach for the hammer.

If you do use a SAFE, which one? The Y Combinator forms are the most common starting points, but in a Reg CF offering, you should make at least three changes:

  1. The Y Combinator form provides for conversion of the SAFE only upon a later sale of preferred stock. That makes sense in the Silicon Valley ecosystem because of course the next stop on the assembly line will involve preferred stock. Outside Silicon Valley, the next step could be common stock.
  2. The Y Combinator form provides for conversion of the SAFE no matter how little capital is raised, as long as it’s priced. That makes sense because on the Silicon Valley assembly line of course the next step will involve a substantial amount of capital from sophisticated investors. Outside Silicon Valley you should provide that conversion requires a substantial capital raise to make it more likely that the raise reflects the arm’s-length value of the company.
  3. The Y Combinator form includes a handful of representations by the issuer and two or three by the investor. That makes sense because nobody is relying on representations in Silicon Valley and nobody sues anyone anyway. In Reg CF, the issuer is already making lots of representations —Form C is really a long list of representations — so you don’t need any issuer representations in the SAFE. And dealing with potentially thousands of strangers, the issuer needs all the representations from investors typical in a Subscription Agreement.

The founder of a Reg CF funding portal might have come from the Silicon Valley ecosystem. In fact, her company might have been funded by SAFEs. Still, she should understand where SAFEs are appropriate and where they are not and make sure investors understand as well.

Questions? Let me know.

SEC Proposes Major Upgrades To Crowdfunding Rules

The SEC just proposed major changes to every kind of online offering:  Rule 504, Rule 506(b), Rule 506(c), Regulation A, and Regulation CF.

The proposals and the reasoning behind them take up 351 pages. An SEC summary is here, while the full text is here. The proposals are likely to become effective in more or less their existing form after a 60-day comment period.

I’ll touch on only a few highlights:

  • No Limits in Title III for Accredited Investors:  In what I believe is the most significant change, there will no longer be any limits on how much an accredited investor can invest in a Regulation CF offering. This change eliminates the need for side-by-side offerings and allows the funding portal to earn commissions on the accredited investor piece. The proposals also change the investment limits for non-accredited investor from a “lesser of net worth or income” standard to a “greater of net worth or income” standard, but that’s much less significant, in my opinion.
  • Title III Limit Raised to $5M:  Today the limit is $1.07M per year; it will soon be $5M per year, opening the door to larger small companies.

NOTE:  Those two changes, taken together, mean that funding portals can make more money. The impact on the Crowdfunding industry could be profound, leading to greater compliance, sounder business practices, and fewer gimmicks (e.g., $10,000 minimums).

  • No Verification for Subsequent Rule 506(c) Offerings:  In what could have been a very important change but apparently isn’t, if an issuer has verified that Investor Smith is accredited in a Rule 506(c) offering and conducts a second (and third, and so on) Rule 506(c) offering, the issuer does not have to re-verify that Investor Smith is accredited, as long as Investor Smith self-certifies. But apparently the proposal applies only to the same issuer, not to an affiliate of the issuer. Thus, if Investor Smith invested in real estate offering #1, she must still be verified for real estate offering #2, even if the two offerings are by the same sponsor.
  • Regulation A Limit Raised to $75M:  Today the limit is $50M per year; it will soon be $75M per year. The effect of this change will be to make Regulation A more useful for smaller large companies.
  • Allow Testing the Waters for Regulation CF:  Today, a company thinking about Title III can’t advertise the offering until it’s live on a funding portal. Under the new rules, the company will be able to “test the waters” like a Regulation A issuer.

NOTE:  Taken as a whole, the proposals narrow the gap between Rule 506(c) and Title III. Look for (i) Title III funding portals to broaden their marketing efforts to include issuers who were otherwise considering only Rule 506(c), and (ii) websites that were previously focused only on Rule 506(c) to consider becoming funding portals, allowing them to legally receive commissions on transactions up to $5M.

  • Allow SPVs for Regulation CF:  Today, you can’t form a special-purpose-vehicle to invest using Title III. Under the SEC proposals, you can.

NOTE:  Oddly, this means you can use SPVs in a Title III offering, but not in a Title II offering (Rule 506(c)) or Title IV offering (Regulation A) where there are more than 100 investors.

  • Financial Information in Rule 506(b):  The proposal relaxes the information that must be provided to non-accredited investors in a Rule 506(b) offering. Thus, if the offering is for no more than $20M one set of information will be required, while if it is for more than $20 another (more extensive) set of information will be required.
  • No More SAFEs in Regulation CF:  Nope.

NOTE:  The rules says the securities must be “. . . . equity securities, debt securities, or securities convertible or exchangeable to equity interests. . . .” A perceptive readers asks “What about revenue-sharing notes?” Right now I don’t know, but I’m sure this will be asked and addressed during the comment period.

  • Demo Days:  Provided they are conducted by certain groups and in certain ways, so-called “demo days” would not be considered “general solicitation.”
  • Integration Rules:  Securities lawyers worry whether two offerings will be “integrated” and treated as one, thereby spoiling both. The SEC’s proposals relax those rules.

These proposals are great for the Crowdfunding industry and for American capitalism. They’re not about Wall Street. They’re about small companies and ordinary American investors, where jobs and ideas come from.

No, the proposals don’t fix every problem. Compliance for Title III issuers is still way too hard, for example. But the SEC deserves (another) round of applause.

Please reach out if you’d like to discuss.