Crowdfunding and the Not-So-Safe SAFE

December 9, 2016Publications
Originally published by: SSRN - 102 Virginia Law Review Online 168 (2016)

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, we believe that 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, is sold or goes public.

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 capital — or a return of their original investment amount — 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 only invest in companies they expect will successfully raise venture capital in short order following their investment. By contrast, retail investors who invest in SAFEs offered by companies that are unlikely to raise venture capital may not fully appreciate the risks that they are taking by purchasing those SAFEs.

There are a number of ways by which this mismatch between instrument and company might be addressed. Our preferred approach is for the funding portals simply to remove the SAFE from their menu of financing instruments. A crowdfunding company that is a likely candidate for raising future venture capital and wants to issue a SAFE-like security could instead issue a standard convertible note, which is similar to the SAFE in many respects but offers more protections to retail crowdfunding investors. Alternatively, the company could issue debt, common equity or preferred equity. These alternatives are, in our view, more suitable vehicles for channeling retail investment capital to crowdfunding companies than is the SAFE.