SAFE stands for Simple Agreement for Future Equity, and they are simple. They’re fantastic, actually, but do crowdfunding investors understand what they are receiving when they "invest" in a young company and get SAFEs in return?
Properly used, SAFEs serve a great niche in the investment world. But without proper disclosure and education, sadly, in time, SAFEs may discourage and disillusion investors who hoped to participate in the success of small start-up companies.
Reg CF of the JOBS Act
On May 16, 2016, Title III of the Jumpstart Our Business Startups Act (JOBS Act) went into effect, also known as Reg CF. It allows small companies to use crowdfunding platforms to raise up to $1 million in a 12-month period from non-accredited investors.
Traditionally, U.S. law as enforced by the Securities Exchange Commission (SEC) has not allowed companies who are not publicly listed on a stock exchange to solicit investments from non-accredited investors except with very few exceptions. Accredited investors fund over a trillion dollars each year, but constitute only a small percentage of the population. They are generally believed to be wealthy or sophisticated and therefore presumably better equipped to make investment decisions and protect themselves from bad investments.
Reg CF of the JOBS Act allows small, non-accredited investors to contribute to small start-ups via crowdfunding platforms. Recognizing a need to protect investors while allowing them to partake in the global crowdfunding phenomenon, Reg CF was designed to let the little guy invest in private companies that they wanted to support but weren’t able to otherwise due to securities laws. But do they realize what they're getting for their money?
SAFEs are Not Bonds or Shares of Stock
The most well-known tech accelerator or incubator is Y Combinator. They created the SAFE structure back in 2013 to fund seed-stage start-ups.
The SAFE is a contract, like a warrant, entitling the holding to shares of stock, usually preferred, if and when there is a future "valuation event." Typically, there are three possible such events:
· The company raises equity capital,
· The company is acquired, or
· The company goes public.
What are You Really Getting in Return for Your Money?
SAFEs do not pay or accrue interest, usually do not have maturity dates, do not represent equity, and generally do not give you a vote in running the company. The company has indefinite use of your money and its only obligation is to give you some stock if and when there is a triggering event. The way it’s generally structured, it’s possible for investors to never get anything, even if the company is successful.
This works for professional angel investors who understand the risks and rewards. However, the people who targeted in Reg CF transactions often do not have the experience to properly analyze a SAFE. Many dream of getting in on the next Amazon or Google at the ground floor, and they may find themselves disappointed when the company they’ve invested in is good, but the investment terms were bad.
What are the Odds the Company Will Raise Venture Capital?
Nobody knows yet. For tech start-ups nurtured by Y Combinator, it's almost a sure thing. However, that's not true of many other types of small businesses.
It's possible that some of the Reg CF companies will grow into successful businesses without ever returning much money to the initial crowdfunding investors. If the business fails, as many will, investors are likely to see a total loss of their investment.
What if it Never Converts?
WeFunder, the most active Reg CF crowdfunding platform at the moment, has a form SAFE that does not always convert even if the company raises capital by selling equity shares of stock. It does not convert until the company selling preferred stock, which might never happen.
They Can Just Buy My SAFE Back?
Republic, another Reg CF crowdfunding platform, has a form SAFE that allows a company to just redeem a SAFE from its investors (and WeFunder’s allows the same). These provision can be easily overlooked by inexperienced investors. People who crowdfund look forward to participating in its success. How will they react to having taken all the risk only to have a company redeem their investment and not share the upside with them?
To be fair, we’re ok with SAFEs. They’re neither good nor bad. Properly used, they can be the right instrument for a capital raise. We’re not suggesting that they shouldn’t be used for Reg CF crowdfunding. We just think that there needs to be better education and disclosure to investors so that they understand exactly what they’re investing in when they get a SAFE.