SAFEs or Simple Agreements for Future Equity are popular investment options for early stage startups that are not quite ready to peg a value on the company. They are also commonly used on investment crowdfunding platforms. SAFEs typically represent an opportunity to purchase stock at a discount at a future date, usually triggered by an event. This trigger is frequently associated with a future funding round where a valuation is applied – perhaps a VC round. Some SAFEs, such as Republic’s Crowd Safe allow founders to ‘roll over’ this conversion until a change of control – such as a merger, sale of the company or a public offering of the company’s stock.
Last year, the Securities and Exchange Commission (SEC) came out with a public warning telling investors to “be cautious of SAFEs in crowdfunding. They pointed out that SAFEs are not common stock, with no upfront equity. SEC Commissioner Michael Piwowar stated;
“In contrast to the sophisticated venture capital investors for whom SAFEs were originally intended, Regulation Crowdfunding [Reg CF] is designed to serve as a new method of raising capital from a broad, mostly retail base of investors … Intermediaries face a real challenge in educating potential investors about this high-risk, complex, and non-standard security when the security itself is entitled “SAFE.”
In brief, Commissioner Piwowar is of the opinion SAFEs are neither simple nor very safe, at least for smaller investors.
The counterargument to the SEC’s cautionary statement is that SAFEs are very founder friendly. Investing in an early stage firm is a risky bet. Many, if not most, startups fail, wiping out any equity position. As an investor in an early stage company you want the founder to be fully focused on executing on his or her vision of the company and the service or product provided. They should not be spending their time with every trivial shareholder request. Furthermore, Reg CF provides reporting duties for issuing companies, ensuring investors will have information about their investment. Finally, many have argued that voting rights for a $50 investor in a multi-million-dollar company provide no true ability to affect the company’s direction making them a ministerial headache.
One industry participant countered the SECs position on SAFE asking, rhetorically, what the Commission was comparing SAFEs to?
While admitting that SAFEs are not as “simple” as common stock, this person said that putting a valuation on equity of a non publicly traded start up is not only quite complicated but utterly impossible.
“In fact the only thing you know about the valuation of a start up, is that it is wrong.”
In some respects, a SAFE is akin to an option that you may exercise, or not, depending on the success of the firm. If a firm fails, whether you hold a SAFE or common equity, you are out of luck and will need to write the investment off. The same may be true for most debt depending on how it is collateralized.
But regarding SAFEs, the devil is in the details. Too many people do not actually read the small print of the offering document or, perhaps, they simply do not understand the jargon. Not all SAFEs are created the same. Some may have a fantastical trigger point that will never occur. It can be challenging to discern between a SAFE that may payoff or one that is rigged to shortchange smaller investors.
Republic, a mission driven crowdfunding platform that is an offshoot of AngelList, has led an effort to create a solution for investors. Understanding that education is necessary in a new industry and transparency is the best policy when it comes to early stage investing, the dev team at Republic helped build an open-sourced SAFE evaluation website. Anyone may key in the terms of the SAFE from any platform or any offering (Reg CF or otherwise) using a SAFE to better understand if and when they may drive a return on their investment.
A SAFE can be structured to be have a trigger at an event where the investor receives a percentage discount, at a hard valuation or both. The SAFE site allows investors to plug in the information to see what an expected return may be if a trigger event occurs.
But even with this helpful site, Republic cautions investors to be certain to read, and understand, what they are purchasing when they back a private company.
“SAFEs are popular because they push back the need to establish a valuation. If a firm values their company either too high or too low, when there is little to no operating information, this can create unneeded problems and undermine a company’s potential for success,” says Maxwell R. Rich, General Counsel at Republic. “If the company is valued too high, it may forgo any future investments or may even necessitate a down round – harming early investors and the founders, who will likely experience dilution. If the valuation is too low, the founder may find themselves extraordinarily diluted, perhaps to the degree that it mitigates the incentive to drive returns. It is really a fine line that both parties must walk and understand.”
While all US based crowdfunding platforms are offering SAFEs, these offerings are not all of the same. Based off of the original Y-Combinator documents, several platforms, including Republic, have created bespoke SAFEs striving for a more balanced approach to facilitate both investor and issuer goals.
Republic’s standard Crowd Safe, which is structured to reduce an issuing company’s operating burdens while protecting investors economic rights, is customizable, allowing companies to add provisions such as a “right of repurchase”, escrow provisions to ensure investors see a partial return in the event of a dissolution, and other clauses to better match each issuing company’s particulars with an investors demands.
In the end, it is an investor’s responsibility to be cautious whether purchasing debt, equity, a convertible or a SAFE. Early stage investing can be highly rewarding but outsized returns are always paired with heightened risk and a real risk of loss of principal.
[Editors Note: Individuals interested in helping the “open-sourcing” may email firstname.lastname@example.org]
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