A Reply on the Use of SAFEs in Crowdfunding
On September 22nd, Crowdfund Insider published a post summarizing the arguments presented in our new essay entitled “Crowdfunding and the Not-So-Safe SAFE“ (forthcoming in Virginia Law Review Online). Our essay raises a number of concerns about how some companies are, in our view, potentially misusing to the detriment of investors a particular type of startup financing instrument—the simple agreement for future equity or “SAFE”—in retail investment crowdfunding offerings under Title III of the JOBS Act and Regulation Crowdfunding.
On September 27th, Amy Wan, a crowdfunding lawyer and Crowdfund Insider Senior Contributor, published a response to our paper. We appreciate Crowdfund Insider giving us this opportunity to respond to some of the objections and arguments raised by Ms. Wan. Instead of providing a line-by-line refutation of the criticisms Ms. Wan has leveled against our essay (which we assume would be of little interest to most readers), we have focused on a few of the most important points we thought worth addressing and clarifying.
Will they raise VC money, or will they not raise VC money? That is the question.
Let’s start with what appears to be Ms. Wan’s most strenuous objection to our essay—that our assumption that many Regulation Crowdfunding companies issuing SAFEs are unlikely ever to raise institutional venture capital is, in her opinion, “baseless.” She points to data from the popular funding portal WeFunder (whose CEO, Nicholas Tommarello, she quotes extensively in her article) in an attempt to dispute our premise.
It is far too early to arrive at an empirical conclusion on this point given the extremely limited data set to date—Title III crowdfunding only began six months ago, on May 16th of this year. The few examples Ms. Wan does point to, however, do not undercut our assumption.
Ms. Wan identifies several crowdfunding issuers that used WeFunder’s SAFE in their crowdfunding offerings. A subset of those crowdfunding issuers had previously raised capital using SAFEs or convertible notes in traditional seed financings outside the crowdfunding context. She claims that the investors in those previous offline rounds were “professional” investors—based on what, we cannot tell. Nonetheless, there is a significant difference between raising a seed round from accredited angel investors (the vast majority of whom are actually not professional investors) and successfully completing a Series A equity financing round with institutional venture capital funds. The fact that a few of these issuers were able to convince small groups of accredited investors (many of whom are often friends and family) to provide seed capital using convertible notes or SAFEs is not evidence that those companies are likely candidates for future institutional venture investment. Thus, even these limited data do not negate our assumption that most crowdfunding issuers may have significant difficulty following their crowdfunding rounds with a successful attempt to raise money from institutional venture capital funds.
Ms. Wan also gives short shrift to the reasoning supporting our assumption: (1) many crowdfunding issuers have business models that are not typically attractive to institutional VC investors, and (2) even the ones who have such a business model may still be less likely to successfully raise that type of capital due to adverse selection, i.e. the significantly higher costs and ongoing disclosure obligations of crowdfunding offerings when compared to traditional seed financings.
Since none of us can say with certitude (or even confidence) that crowdfunding issuers raising seed capital using SAFEs will be anywhere near as likely in the long run to raise institutional venture capital as the startups using SAFEs outside the crowdfunding context, we believe that—based on the rationales we provided—a modicum of circumspection is warranted.
Objections to—and Misunderstandings of—Our Proposals
Contra Ms. Wan’s somewhat hyperbolic take on our essay, we have not proposed “banning” the SAFE from crowdfunding offerings—at no point do we go so far as recommending that Congress or the SEC should restrict the types of securities permitted. We have suggested that the most prudent course may be for the funding portals to consider proactively removing the SAFE from their menu of suggested crowdfunding securities. Another of our proposals—which falls short of the funding portals removing their SAFE forms entirely—is for the portals to provide some level of curation by attempting to ensure that SAFEs and other convertible securities (such as convertible notes) are only used by companies that seem well positioned to raise institutional capital in the future.
Ms. Wan incorrectly stated that the SEC’s final crowdfunding rules forbid this. The proposed Regulation Crowdfunding did restrict this type of curation, but the final rules expressly allow it. The SEC’s final rule release (pp. 276-77) reads as follows:
Final Rules. In view of the comments, and upon further consideration, we are modifying Rule 402(b)(1) [of Regulation Crowdfunding] to expressly provide that a funding portal may … determine whether and under what terms to allow an issuer to offer and sell securities in reliance on Securities Act Section 4(a)(6) through its platform.
We agree with commenters that the ability of a funding portal to determine which issuers may use its platform is important for the protection of investors, as well as to the viability of the funding portal industry, and thus the crowdfunding market. We acknowledge the concerns raised by commenters that the proposed rules could otherwise have unduly restricted a funding portal’s ability to limit offerings conducted on its platform, and we are modifying the safe harbor contained in Rule 402(b)(1) to address these concerns. … The new language is designed to make it clear that a funding portal may exercise its discretion, subject to the prohibition in the statute on providing investment advice or recommendations, to limit the offerings and issuers that it allows on its platform under the safe harbor, as long as it complies with all other provisions of Regulation Crowdfunding.
One of our biggest concerns with the use of SAFEs in crowdfunding is that early investors who contribute seed capital in exchange for those securities in the crowdfunding issuers that do become successful businesses will be denied a return on their investment commensurate with the risk assumed because of the type and terms of the security currently being used in these offerings. We believe that, if this turns out to be the case, the resulting backlash may imperil the overall crowdfunding project.
While the crowdfunding issuers and their counsel could (as Ms. Wan pointed out) make changes to the SAFE forms provided by portals such as WeFunder to address some of the concerns we have raised, none appear to be doing so. Furthermore, provisions like the redemption feature that WeFunder and others have added to Y Combinator’s SAFE have made an already company-favorable instrument even more so by allowing the company to buy out early crowdfunding investors. This provision deprives those who took the most risk of the bulk of their potential upside. Ms. Wan neglected to address this particular “innovation” in her article.
In their real struggle to make a workable system in which young, inexperienced companies with few resources have to manage taking capital from potentially thousands of investors, some funding portals have responded by pushing SAFEs and adding new features like the redemption provisions, delayed conversion, and conversion to non-voting stock. Unfortunately, this approach tips the balance of power so far in favor of the company that it leaves prospective crowdfunding investors in an extremely precarious position.
We continue to believe that, by taking this approach, those most interested in crowdfunding’s success (the funding portals, attorneys and other service providers attempting to create niche practices in the space) may be shooting themselves in their collective foot. Shooting the messenger won’t help.
John Coyle is an Associate Professor at the University of North Carolina School of Law. He teaches and writes about venture capital. Prior to joining the faculty at UNC, he clerked for Judge Reena Raggi on the U.S. Court of Appeals for the Second Circuit and worked as an associate at Covington & Burling LLP in Washington D.C.
Joe Green writes Thomson Reuters Practical Law’s startup and venture capital content and is a principal member of the Practical Law Startup Resource Group, working across practice areas to develop relevant know-how materials for practitioners in the startup space. He writes and speaks frequently on crowdfunding and other startup law topics. Prior to joining Practical Law, Joe was a senior attorney at Gunderson Dettmer, where he advised startups, entrepreneurs, and premier venture capital investors on a wide range of legal and business issues. After graduating from UVA Law, he began his career as a securities lawyer with Simpson Thacher & Bartlett in New York.