The SEC recently warned investors about a popular Reg CF security called a ‘SAFE’—Simple Agreement for Future Equity. The Commission is concerned those purchasing SAFEs may be unaware of their risks. It thinks they should be cautious of this “exotic” Silicon Valley security.
Although SAFEs have drawbacks, if done with favorable terms they provide potentially big returns. They also give early stage companies freedom to manage initial growth without the burdens associated with other securities. Investors should always weigh risks but SAFEs are not inherently unsafe, they can benefit both startups and early investors.
SAFE’s Silicon Valley origins don’t make them unsafe
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 arose as an alternative to the convertible notes Silicon Valley startups provided early investors. These contracts 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 rises 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 appeal. They are not debt so accrue no interest and, of course, they may never convert if the triggering event doesn’t happen.
SAFE’s can benefit young companies and investors
But the factors that work against SAFEs investors have reciprocal benefits for young companies. They provide capital without strings that stifle flexibility in early stages and allow the company to quickly adapt. The documents are relatively simple mean less time for tedious negotiations. 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 trust SAFE’s?
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. They should provide perks and very favorable terms with market caps and discount rates. They should also realize they are competing against 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.