The SEC recently warned equity crowdfunding investors about a popular Reg CF security called a ‘SAFE’—Simple Agreement for Future Equity. The Commission is concerned investors purchasing SAFEs may be unaware of their risks and should be cautious of this “exotic” Silicon Valley security.
Although SAFEs have drawbacks for early investors, if done with favorable terms they provide potentially big returns while giving early stage companies freedom to manage initial growth without the burdens associated with traditional securities. Investors should always weigh risks and understand their investments but SAFEs are not inherently unsafe, they can benefit both startups and early investors.
SAFE’s are a product of Y Combinator, rated by Forbes the most successful startup incubator. Its companies have a combined valuation of $8 billion and include well-known names like Reddit and Airbnb. SAFEs were born as an alternative to the convertible notes Silicon Valley startups provided early investors, which featured sometimes-burdensome interest rates and maturity dates.
As the SEC notes, SAFEs are not equity or debt, like a warrant they promise future equity if the company reaches certain benchmarks or triggering events. These could include future funding rounds, acquisition, or IPO. A SAFE in essence rewards early investors willing take bigger risks with larger returns if the company progresses as forecast.
This promise, however, comes with drawbacks on the investor side. Investors don’t get immediate ownership as they would with common stock. They have no voting rights and, there may be buyout clauses, or repurchase rights that could lessen the SAFE’s appeal. They are not debt so accrue no interest and, of course, they may never convert if the triggering event doesn’t happen.
But the factors that work against SAFEs investors have reciprocal benefits for young companies. They provide capital to entrepreneurs without strings that stifle flexibility and innovation in the early stages and allow the company to adapt to market conditions. The security documents are relatively simple meaning less time for tedious negotiations over details germane to bigger financing rounds. And the lack of voting rights or maturity dates allows entrepreneurs flexibility to grow without the burden of multiple owners or the threat of looming debt payments.
Should Reg CF investors invest in SAFEs?
Many companies considering equity crowdfunding fit the SAFE model. They are early stage ventures with limitless potential but need quick, simple financing to implement next-level growth or reach benchmarks that trigger future funding. As with any investment, the terms are paramount. Does the SAFE come with a generous valuation cap or discount rate that adequately rewards early investors taking bigger risks and granting more autonomy? These details inform whether a particular SAFE is worth the risk.
Companies offering SAFEs on Reg CF should realize these bigger investor risks and provide perks and very favorable terms with market caps and discount rates. They should also realize they are competing against other SAFEs and instruments that give investors more upfront security.
But generally SAFEs are not unsafe, they require a bigger risk upfront for a heftier reward later on.
This post is not legal or financial advice. Investors should consult a lawyer before purchasing any financial instrument through Reg CF.
By Jossey PLLC
Few issues in Washington get prodigious bipartisan support, but the 2012 JOBS Act’s equity crowdfunding title was one. After a long delay, Reg CF finally went live in last May.
But a year on some are asking, ‘Where is the Crowd?’ The crowdfunding total is approaching $40 million but it should be billions. A recalcitrant SEC and onerous regulations are two possible answers to why equity crowdfunding has experienced steady but unspectacular growth in year one.
To solve this, the House passed the Financial CHOICE Act. Although mostly a remedy to Dodd Frank, the Act includes a complete overhaul of equity crowdfunding. In fact, it includes a complete deregulation. According to CrowdfundInsider.com:
- gone are limits on how much a company can raise;
- gone are requirements for financial statements or, for that matter, any other type of disclosure;
- gone are requirements to file annual reports after completing a raise;
- gone is the risk of inadvertently becoming a fully reporting company, as purchasers of these securities are not counted towards the 500 non-accredited shareholder limit;
- gone is the requirement to conduct the offering on an SEC and FINRA registered portal;
- gone are restrictions on “off portal” solicitation and advertising; and
- gone are the restrictions on how much an investor can invest.
The chances of complete deregulation are slim. First, the bill has yet to face the Senate where some or all of it could be tossed in reconciliation. Second, the SEC must implement what survives. Some have accused the agency as being openly hostile to the very idea of crowdfunding. As Edward Knight, Executive Vice President and General Counsel of NASDAQ, stated in a March JOBS Act hearing for the House Committee on Financial Services:
From the outset the SEC’s view of [equity crowdfunding] was they were not for this they and made it shall I say needlessly complicated and did not approach it except as this this was something where the public is going to get harmed and we need to narrow it as much as possible.
At the very least, the SEC doesn’t seem to react well to change. Acting SEC Chairman Michael Piwowar described the changes the JOBS Act makes to the SEC’s mission this way:
The JOBS Act requires the Commission to think of capital formation and investor protection in fundamentally different ways than we have in the past. The crowdfunding provision of the JOBS Act forces us to think outside of our historical securities regulation box and to create a different paradigm than the one we have used for the past eight decades.
Whether through the CHOICE Act or a standalone bill, equity crowdfunding needs changes to reach its potential to provide much needed capital to America’s entrepreneurs and small businesses. The sooner Congress enacts these reforms the faster America’s economic engine can start humming again.
By Jossey PLLC
Equity crowdfunding celebrated its first birthday last week. The innovative securities law democratizes business capitalization and allows anyone to potentially make a bundle on a young company. Although Congress must tweak the law to realize its potential the future looks bright.
The naysayers fretted equity crowdfunding wouldn’t work. They said scandal and fraud would taint the process. Thus far they are wrong; the system of checks and balances between accountants and lawyers representing companies and due diligence by funding portals has combined to root out fraud while educating investors about the risks.
According to Catherine Yushina, COO & Co-Founder of Startwise, so far 265 companies have entered the equity crowdfunding market aggregating an impressive $37 million in investment. Around half have successfully completed a fundraising round.
But this is just the beginning. There are approximately 100 million startups opening each year and only 798 venture capital funds in the U.S. And of existing small businesses, 80% have never considered alternative funding options. That is changing rapidly. In the next few years the alternative funding market will grow to 20% of small business capitalization.
Early adopters represent a wide-range of industries including tech, real estate, fashion, sports, and entertainment. Food & Beverage and Wine & Spirits lead taking a combined almost $11 million.
But it’s not just about the boon to new businesses needing capital. On the giving end, millions of people now have the opportunity to invest in newest companies at a fraction of previous amounts. Before Title III of the JOBS Act the SEC only allowed “accredited investors” to participate in crowdfunding. This represented about 8 million people. Now around 240 million people can invest in potentially lucrative ventures at their beginning stages.
More exciting is that confidence is growing in the new markets. According to We-Funder, the average early investment was under $250, by the end 2016 it had jumped to $833 per person.
Seeing the success rewards based crowdfunding platforms have started offering securities. Crowdfunding platform giant Indiegogo is an impressive 12 for 12 in successful startup funding.
The future looks bright but Congress still has a role. When the SEC finalized the rules, it determined limits from the statute. Instead of taking the higher of annual income and net worth as the operative number to base the limit it went with the lower.
This can be big a difference. For instance under this approach, an investor with annual income of $50,000 a year and $105,000 in net worth would be subject to an investment limit of $2,500, in contrast to the proposed rules in which that same investor would have been eligible for an investment limit of $10,500. Using this lower limit hampers a startup’s most fervent supporters from pushing a potential issue over the top. Moreover, the overall limit of a little over $1 million per year is too low for many crowdfunded projects and harms market fluidity and dynamism. Another current proposal calls for tax credits for equity crowdfund investors.
While Congress hashes out improvements, the future of equity crowdfunding is bright. Given the number small businesses and startups in the US and the number of potential investors analysts could be discussing future birthdays in terms of billions, not millions.
By Jossey PLLC