Crowdfunding and the Not-So-Safe SAFE
By: Joe Green and John Coyle
On May 16, 2016, the much-anticipated era of retail crowdfunding officially began in the United States. While it is far too early to pass judgment on the long-term prospects of the crowdfunding project more generally, it is possible at this juncture to assess how certain aspects of crowdfunding are developing. With respect to the menu of financing instruments being offered to prospective investors, early market participants are potentially sabotaging the crowdfunding experiment by making widespread use of a relatively new startup-financing instrument—the simple agreement for future equity (SAFE)—that may frustrate the ability of investors to share in the upside of successful crowdfunding companies.
The SAFE was developed by Y Combinator, the well-known startup accelerator based in Silicon Valley, as a means of investing in startups that expected to raise institutional venture capital at a later date. Although the SAFE resembles a classic seed-stage convertible note in most respects, it lacks the convertible note’s maturity date and does not accrue interest while it remains outstanding. It does not pay dividends, and the SAFE holder has no right to vote on matters submitted to shareholders. The SAFE is, in essence, a contractual derivative instrument that amounts to a deferred equity investment. It will prove valuable to the holder if, and only if, the company that issues it raises a subsequent round of financing or is sold.
The key problem with the use of SAFEs in crowdfunding is that many of the companies issuing them are unlikely ever to raise institutional venture capital. If a crowdfunding issuer never raises this type of capital, then the retail investors who hold that issuer’s SAFEs may find themselves in possession of a security that, in addition to granting the holder no voting rights or other investor protections, may never provide them with a return on their investment or a return of their principal even if the company is successful. Sophisticated investors who invest in SAFEs in the context of early-stage technology companies knowingly assume these risks because they expect these companies to successfully raise venture capital in short order following their investment. Retail investors who invest in SAFEs in the context of a crowdfunding company that is unlikely to raise venture capital, by contrast, may not fully appreciate the risks that they are taking.
In addition to these general concerns about the use of SAFEs in crowdfunding, we also believe that the specific SAFEs currently offered by crowdfunding portals such as WeFunder and Republic contain terms that are likely to frustrate the ability of investors to share in the upside of successful crowdfunding companies. The WeFunder SAFE, for example, states that a financing conversion only occurs under the contract when the issuer closes a bona fide preferred stock financing raising any amount at a fixed pre-money valuation. The SAFEs do not convert if the company raises equity capital by selling common stock. Under the terms of the WeFunder SAFE, a company could theoretically raise unlimited amounts of private capital selling common stock and distributing profits to those investors and the founders via dividends without ever triggering a conversion of the SAFEs or allowing the SAFE holders to participate in those dividend payments. The Republic SAFE, which includes a troubling redemption feature by which a company can call its SAFEs from all non-accredited investors, also (like WeFunder’s SAFE) neglects to account for a scenario in which the stockholders of the company receive their return in the form of dividends and not in a liquidity event such as a sale or IPO.
There are several possible solutions to the problems identified above. First, the funding portals could seek to limit the use of SAFEs to the “right” sort of companies—those that are likely to raise future capital from institutional investors. While policing the types of securities offered by crowdfunding companies may sound like a lot to ask of the portals, many of them already market themselves as significantly curating the offerings they make available on their platforms. Second, the portals could amend the forms of SAFE currently on offer to address some of the specific issues we have raised. This would be a positive development, to be sure, but it would not address the deeper problems that flow from the fact that many of these crowdfunding issuers will never raise institutional venture capital.
Finally, the funding portals could remove the SAFE from their menu of financing instruments. We believe that this last approach represents the simplest and best solution to the various problems identified above. If a company wants to issue a SAFE-like security, it can always issue a convertible note, which is similar to the SAFE in many respects but which pays interest, has a maturity date, and offers other protections that are associated with debt instruments. Alternatively, the company could issue debt, common equity, or preferred equity (the latter two providing investors with the full benefit of being shareholders of the company, including most importantly, the protection of fiduciary duties owed by the company’s board of directors). All of these alternatives are, in our view, more suitable vehicles for investing in crowdfunding companies than is the SAFE. While the SAFE may have an important role to play in providing capital to early-stage companies outside of the crowdfunding context, it is not the right tool for channeling retail investment capital to crowdfunding companies.
The full paper is available for download here.