SEC Rightly Concerned about 'So-Called SAFE' Securities in Crowdfunding
Author: Joe Green
NEW YORK (Thomson Reuters Regulatory Intelligence) - The U.S. Securities and Exchange Commission, released an investor bulletin earlier this month (here) cautioning retail investors about the risks of purchasing a particular type of security known as a Simple Agreement for Future Equity, or SAFE, in investment crowdfunding offerings. The commission acted following concerns raised by two of its commissioners and its Office of Investor Advocacy. It was right to do so.
Regulation crowdfunding — the SEC’s rules allowing startups and small businesses to raise just over $1 million of capital from non-accredited, retail investors through online crowdfunding portals — became effective a year ago this month. These long-awaited regulations implemented the crowdfunding provisions of Title III of the Jumpstart Our Business Startups (JOBS) Act of 2012. Unlike popular crowdfunding platforms like Kickstarter, through which participants can make donations to for-profit businesses in exchange for rewards, investors participating in offerings under Regulation Crowdfunding receive securities (such as equity or debt) in exchange for their investments in fledgling companies.
The SEC’s Division of Economic and Risk Analysis (DERA) has published a white paper analyzing all offerings launched under Regulation Crowdfunding from its May 16, 2016 effective date through the end of that year. To give a sense of the types of companies that have tried to raise capital using investment crowdfunding, according to DERA, the median issuer under Regulation Crowdfunding was incorporated within the last two years and had only three employees, no revenues and around $5,000 in cash and $10,000 in debt on its balance sheet. About 60 percent of crowdfunding issuers showed no revenues and 91 percent had yet to earn a profit.
When the SEC analysts looked at the types of securities that Regulation Crowdfunding issuers chose to offer to prospective investors, they found that common and preferred equity were most frequently offered, accounting for more than a third of the offerings. However, the next most commonly offered security, accounting for just over a quarter of the offerings, was the SAFE.
THE SIMPLE AGREEMENT FOR FUTURE EQUITY
As I described at length in a 2014 Hastings Law Journal article on contractual innovation in venture capital (here) that I co-authored with John Coyle, an associate professor at the University of North Carolina at Chapel Hill, the SAFE is a relatively new startup financing instrument developed and popularized by the influential Silicon Valley startup accelerator Y Combinator. The SAFE was designed to facilitate investments by wealthy, sophisticated angel investors in early-stage technology startups that were expected to raise institutional venture capital (VC) in the near future.
A type of deferred equity contract, SAFEs entitle investors to receive a company’s equity securities upon certain triggering events, such as a subsequent VC investment. Unlike their close cousins, convertible notes, SAFEs do not accrue interest while outstanding and have no maturity date. The percentage of the company’s equity a SAFE investor may eventually receive upon a subsequent financing is a function of the amount invested and the valuation of the company that is negotiated by the later VC investor. Conversion of the SAFE into equity depends upon that future VC financing actually coming to fruition.
CROWDFUNDING AND THE NOT-SO-SAFE SAFE
When Regulation Crowdfunding first went into effect, Coyle and I observed that funding portals and issuers were using SAFEs in the nascent crowdfunding marketplace and decided to investigate. We were alarmed by our findings, which were published by Virginia Law Review Online in a paper entitled "Crowdfunding and the Not-So-Safe SAFE" in December 2016 (here).
Our concerns were largely two-fold. First, we believed that the crowdfunding market suffered from problems of adverse selection; companies that represented ostensibly more attractive investments had cheaper and easier alternatives to raise capital without relying on Regulation Crowdfunding. This would make crowdfunding a financing option of last resort.
Our second concern was that the business models of many crowdfunding issuers made them unlikely candidates for raising institutional venture capital in the future. The combination of these two factors made the SAFE a particularly ill-suited investment vehicle for crowdfunding investors, because the SAFE was specifically designed for companies that are expected to successfully raise institutional VC financing in the near future, and we expected exceedingly few of the crowdfunding companies would actually be able to do so. This could lead, in some cases, to SAFEs remaining outstanding in perpetuity without ever providing a return to the investors holding them.
We also thought that the name of the instrument could be particularly misleading for retail investors. “A potential problem with using SAFEs in crowdfunding,” we wrote, “is that inexperienced retail investors may mistakenly believe that they are receiving something simple and safe, a security that they believe all of the top startups and investors in Silicon Valley use, and make an investment without fully understanding the risks that they are assuming by purchasing those SAFEs.”
The funding portals exacerbated these problems by making certain alterations to Y Combinator’s form of SAFE when they adapted it for use on their platforms. These changes have made it even less likely that retail investors purchasing SAFEs from crowdfunding issuers will share in the upside of even the few successful crowdfunding companies.
When our article was first made public, it received significant pushback from funding portals and other crowdfunding proponents (here). To date, none of the funding portals appear to have dialed down their endorsement of SAFEs or modified the SAFE instruments they promote to address the concerns raised in our paper.
THE SEC ENTERS THE FRAY
In its 2016 Report on Activities, the SEC’s Office of the Investor Advocate discussed the use of SAFEs in Regulation Crowdfunding offerings under the heading “Problematic Investment Products and Practices.” The report stated that “the acronym SAFE seems misleading,” and that “crowdfunding investors may not understand the amount of risk they are assuming, and particularly the possibility that they may not readily reap the benefits from investing in a successful business venture.” The report further speculated along the lines Coyle and I had in our paper that “ultimately, crowdfunding may become an unattractive alternative for investors if their upside potential is severely restricted while they take on the heightened risk of startup investing.”
In February 2017, two months after the Investor Advocate published its report, SEC Commissioner Kara Stein raised concerns (here) of her own about the potential pitfalls for retail investors purchasing SAFEs in crowdfunding offerings. She said that "many small and emerging businesses will never attain the subsequent valuation event" that would trigger conversion of the SAFEs to equity and that "as a result, a retail investor is left with little more than the paper on which the contract is written." Stein queried whether, since "SAFEs arguably provide different rights and restrictions and more risk than what retail investors may typically expect," the SEC should "be looking more closely at these securities particularly for retail investors." She also suggested that "the funding portals that offer and promote SAFEs may have a role to play in this area."
On May 9, 2017, the same day the SEC published its investor bulletin warning crowdfunding investors about the risks of SAFEs, Commissioner Michael Piwowar added his concerns about SAFEs to the public dialogue. Like the Investor Advocate, Commissioner Piwowar took issue with the potentially misleading nomenclature. “In short,” he said, “despite its name, a so-called SAFE is neither ‘simple’ nor ‘safe.’” He further commented that crowdfunding portals “face a real challenge in educating potential investors about this high-risk, complex, and non-standard security when the security itself is entitled ‘SAFE.’” Piwowar concluded his remarks on the subject with a warning: “Companies and their intermediaries should think carefully about how they name or describe their securities. Securities marketed as ‘safe’ or ‘simple’ ought to be just that.”
WHAT COMES NEXT?
With two of the three members of the SEC concerned about the use of SAFEs in crowdfunding, momentum for some type of action appears to be building. SEC Chairman Jay Clayton, having been sworn in to his post only several days before the SEC published the investor bulletin, has yet to weigh in. However, the substantial overlap in the views of Stein and Piwowar reflected by their public statements may mean the SEC is considering taking steps beyond warning investors in a bulletin.
Funding portals and other crowdfunding intermediaries, all of which are regulated by the SEC, should take note and consider implementing the recommendations we made in our 2016 paper before it is too late. Our suggestions included removing SAFEs from the menu of securities they recommend to issuers conducting offerings through their platforms and increasing curation by the portals of offerings where SAFEs are used. If these funding portals continue to dither, they may soon find the SEC forcing their hands, perhaps by adding “suitability” requirements similar to those currently applicable to broker-dealers in other contexts or, alternatively, by restricting the types of securities permitted in Regulation Crowdfunding offerings. For the funding portals still pushing SAFEs, the writing is on the wall.
-- 2016 Report on Activities: here