Are SAFE Notes Not Safe for the General Public?
On March 5th, the SEC proposed changes to the JOBS Act, the first changes since April 2012 when the JOBS Act was first voted into law. Among those proposed changes was an interesting detail: SAFE notes would no longer be permitted in Regulation Crowdfunding. This is a big deal.
We collect all public information on Regulation Crowdfunding offerings through the StartEngine Index, and our data shows that 20.9% of all Regulation Crowdfunding offerings to date have been SAFE notes. That’s 438 companies that have a potential problem on their hands if this change is enacted.
To explain why the SEC proposed banning SAFE notes, and to explain why we don’t allow SAFE notes on StartEngine, I need to back up the timeline and get into a little history.
The Problem With Convertible Notes
In 2013, Y Combinator, the world’s most successful startup accelerator, decided to streamline the process through which their companies raised funding. At that time, the convertible note structure was king. A convertible note is debt that can later convert into equity. Think of it as a loan: an investor loans a company capital, and rather than receiving that money back with interest in the future, the investor receives equity at a discount.
Y Combinator had a few complaints with the structure of convertible notes. They contained several features that Y Combinator felt was not in the best interest of the founders of the startups in their accelerator. Their main objections were:
- Too much time was spent negotiating the terms of a convertible note.
- There was no standard for the legal agreement, causing delays and increased attorney fees.
- The notes usually had a two-year maturity date, at which time the investment needed to be repaid or converted, which could be problematic if the founders needed more time.
SAFE Notes: A Convenient Alternative
To solve these issues, Y Combinator invented the SAFE note. This is an acronym for Simple Agreement For Future Equity. The note was a breakthrough. Many new investments in Y Combinator startups raised funding rounds using SAFE notes.
It offered a standardized solution to convertible notes, which often came with costly delays and legal fees as the founders and investors negotiated the terms of the note. A SAFE offers these standardized terms:
- There is no maturity date on a SAFE note. This means that there is no set time at which the investor must be repaid.
- There is no interest rate on a SAFE note. This means that the SAFE note does not increase in value over time.
- The conversion trigger (what converts the SAFE note into equity) is a future investment made by a qualified investor. In other words, SAFE notes convert if and when the next funding round occurs (usually led by VCs).
- Valuation caps (the highest valuation at which the SAFE note can convert into equity) are beneficial to investors, but they are optional in SAFE notes. Without a valuation cap, SAFE notes could convert into equity at the same valuation as the later funding round.
- SAFE note holders receive preferential treatment if the company has an early exit (whether by acquisition or merger) if the SAFE not has not converted into equity.
In the words of Y Combinator,
“A safe is like a convertible note in that the investor buys not stock itself but the right to buy stock in an equity round when it occurs. A safe can have a valuation cap, or be uncapped, just like a note. But what the investor buys is not debt, but something more like a warrant [a warrant is a security that allows the holder to buy shares at a specified price at or before some future date]. So there is not need to fix a term or decide on an interest rate.
Safes should work just like convertible notes, but with fewer complications.”
A lot of our competitors saw the value of that standardization, with some of them specializing in SAFE offerings. In fact, 50.5% of Regulation Crowdfunding offerings to date on one platform (238 different campaigns) offered SAFE notes to investors. Remember: 20.9% of all Regulation Crowdfunding offerings to date have been SAFE notes.
However, we saw something else in SAFE notes. At StartEngine, we believe they are an unsuitable structure for everyday investors, and we don’t allow them on our platform. Here’s why:
SAFE Notes Are Not So Safe for Crowdfunding
So what happens when you apply SAFE notes to the world of Regulation Crowdfunding? Well, it turns out that what may work for accredited angel investors in a private investment may not quite work for companies seeking to raise capital directly from the general public.
In fact, the SEC issued a bulletin on May 9, 2017 that served as a warning about SAFE notes in the context of equity crowdfunding. In their words, “Despite its name, a SAFE may not be ‘simple’ or ‘safe.’”
Of course, that warning went unheard, and many platforms continued to promote SAFE investment opportunities to this day. In fact, our data shows that SAFE investments make up nearly half of the investment opportunities on some platforms. But why exactly did the SEC issue this warning? Let’s break down the issues with the structure of SAFE notes.
It’s Uncertain When a SAFE Converts
A SAFE does not offer any guarantees the investor will receive equity in the company. The note’s conversion is dependent upon the company raising another funding round. However, the reality is that the chance for a company to raise capital from a venture capital firm or a major investor is very slim. In fact, the entire VC industry only funded 10,777 deals in 2019 (compared to the nearly 6 million small businesses that employ people in the US).
And if the SAFE note never converts? If the company is sold, there is a provision that awards SAFE holders the right to get their money back ahead of the owners of common and preferred shares (but not ahead of debt holders). If that occurs, the valuation cap is used to determine the amount of money the investor is entitled to receive.
However, this creates more uncertainty than a convertible note, which has a maturity date, meaning that investors know that their notes will convert into equity or be paid back by a specific date. SAFE note holders do not have that certainty.
SAFEs Do Not Pay Dividends
SAFE holders are not entitled to dividends in case a company decides to pay them. Dividend payouts are rare with early-stage technology companies, but they are not uncommon for businesses that reach profitability and want to reward their investors with income.
SAFEs Do Not Have Voting Rights
SAFE holders do not have voting rights in the business. While shareholder voting is uncommon for private startups, it is an important part of corporate governance in public companies. SAFE notes offer no voting rights now, or in the future.
SAFEs Create Issues in Secondary Markets
The final disadvantage, and perhaps the most important, is early liquidity. One important feature of Regulation Crowdfunding is that investors can sell their ownership stakes one year after they purchase their investment. Their holdings are tradable after that one-year lock up (disclaimer: there is not currently a marketplace for trading shares purchased through Regulation Crowdfunding or Regulation A+. We are working on solving this problem at StartEngine by launching a secondary marketplace, and our application to launch that marketplace is pending regulatory approval).
If you have a SAFE note that hasn’t converted, how would you value it on a public market? It’s easier to value common shares in a company that releases its financials once a year. Liquidity is important for the everyday investor, and SAFE notes bring up important questions about valuing something that may never convert, with no time table on when that conversion may occur.
Putting the Investor First and Leading the Industry
SAFE notes are great for early-stage technology startups that have a legitimate chance to raise venture capital, but for the new equity crowdfunding economy, they are not well-structured.
Everyday investors don’t understand the risks associated with SAFE notes, and the SEC recognizes that. It’s why they’ve proposed that SAFE notes should no longer be allowed in Regulation Crowdfunding offerings. It’s also why we don’t allow SAFE notes on StartEngine and have had that policy well before any public comment from the SEC.
At StartEngine, we put the investor first, and we want to make sure that every user on our platform understands exactly what they are buying when they invest in a company. Here’s a breakdown of Regulation Crowdfunding offerings on StartEngine:
At StartEngine, we focus on common stock investment opportunities, though some companies choose to offer convertible note, or even debt or revenue share (which are lumped together in the “Other” category).
We are careful and want to do what is best for the investors in our community. We want to make sure the investors who support the companies on our platform are treated fairly and understand exactly what they are receiving in exchange for their money.
But what does the SEC’s announcement mean for the investors who have recently invested in a SAFE? Should the equity crowdfunding platforms cease those companies’ offerings and refund investors? Should the companies restructure the offering into a convertible note?
These issues are critical for investor protection. Platforms who continue to offer SAFEs are doing a disservice to the companies who need capital and to the everyday people who want to invest in those ventures.
If you are one of the 438 companies that raised capital via a SAFE note on another equity crowdfunding platform that specializes in SAFE offerings, reach out to us. We can help.