Month: May 2017

SEC Warns of SAFE Investment Instrument Popular in Equity Crowdfunding Campaigns

The SEC issued a bulletin warning investors about SAFE securities used in equity crowdfunding offerings.

Issuers in equity crowdfunding campaigns have offered various types of securities since it became legal to do so, such as various classes of stock, notes and instruments known as SAFE instruments.  ‘SAFE’ stands for ‘Simple Agreement for Future Equity.’

SAFEs were originally designed to be an alternative to convertible notes for early-stage technology investments.  The idea was that they would become simple, standardized vehicles for investing in very young companies without dealing with a lot the terms needed to make a convertible note or stock investment.

As the SEC points out, a SAFE is not like investing in common stock.  It is an agreement that converts into issuer securities in the event of future triggering events, such as a future investment round, an IPO, a change of control or a liquidation.

Some people seem to think of them like convertible notes.  However, convertible notes have maturity dates, among other terms.  SAFEs do not and may never convert.  SAFEs are more like derivative contracts with springing conversion based on listed events.

SAFEs have been increasing in use in the venture capital and angel investing worlds, and more recently other investors have gained some exposure and comfort with them.  However, the SEC wants investors to know that:

  • SAFEs do not represent a current equity stake in the company in which you are investing.
  • SAFEs may only convert to equity if certain triggering events occur.
  • Depending on its terms, a SAFE may not be triggered.

To the people who have seen them before, none of this is a surprise.  To a new investor, the SEC is concerned that these terms may be unexpected.  As the SEC said:

SAFEs were developed in Silicon Valley as a way for venture capital investors to quickly invest in a hot startup without burdening the startup with the more labored negotiations an equity offering may entail.  Oftentimes, for the venture capital investor, it was more important to get the investment opportunity, and possible future opportunities, with the startup than it was to protect the relatively small investment represented by the SAFE.  In addition, the various mechanisms of the SAFE, from the triggering events to the conversion terms, were designed to best operate in the context of a fast growing startup likely to need and attract additional capital from sophisticated venture capital investors.  This may or may not be the case with the crowdfunding investment opportunity you are exploring.

SAFEs can make a lot of sense to particular parties in particular deals, but investors such as crowdfunding investors should make sure to understand exactly what rights they have in what they are purchasing.

SEC issues warning about SAFE instruments in equity crowdfunding campaigns.
SEC issues warning about SAFE instruments in equity crowdfunding campaigns.

Equity Crowdfunding Risks and Liabilities – Yes, They Do Exist

Sorry startups, you actually have to be careful with equity crowdfunding disclosures. There is substantial risk of liability for securities fraud.

Based on discussions with the equity crowdfunding-curious, people seem to believe that equity crowdfunding is the wild west where anything goes.  Raise lots of money and do it cheaply! Do what you want, say what you want and the SEC does not care!  Look at the Form C’s, there were probably no lawyers anywhere near them.  Think of the savings!!!!

None of that is true.

Done correctly, an equity crowdfunding offering should be done with as much care as any private placement.  The actual information requirements are more extensive than a typical Rule 506 offering.  Most importantly, crowdfunding issuers are subject to the same liability as any other securities selling issuer.

Securities Act Section 4A(c) provides that an issuer will be liable to a purchaser of its securities in a transaction exempted by Section 4(a)(6) if the issuer, in the offer or sale of the securities, makes an untrue statement of a material fact or omits to state a material fact required to be stated or necessary in order to make the statements, in light of the circumstances under which they were made, not misleading . . .

Sound familiar?  What is the difference between this liability and private placements?  Equity crowdfunding is done publicly to more people who are potential claimants.

What does this mean for issuers?  It means the Form C and the offering page on the platform site need to be done carefully and in compliance with SEC rules.  Those rules sound a lot like watered down Regulation S-K rules for MD&A, description of securities, related party transactions, etc…  If you have never complied with them, good luck doing this without experienced help.

Well, at least the platforms are safe, right?  They are just dumb pipes for crowdfunding deals and have no responsibility for what the issuers do on their site, right?

Well, no.  While the SEC did not impose issuer liability on the platforms, it specifically declined to exempt the platforms from liability under Section 4A(c).  Why?  So investors could bring suits against the platforms to make sure that the platforms take steps to keep from becoming conduits of fraud.

The SEC believes that the platforms should take steps to protect themselves.  Congress provided them a defense if they could not have known of an untruth or omission in the exercise of reasonable care.  In other words, the “head in the sand” defense will not work.  In addition, I have seen them provide and even require standard language and provisions in their issuers Form Cs and offering pages.  I doubt the SEC will ignore this if this becomes misleading.

As the SEC stated:

These steps may include establishing policies and procedure that are reasonably designed to achieve compliance with the requirements of Regulation Crowdfunding, and conducting a review of the issuer’s offering documents, before posting them to the platform, to evaluate whether they contain materially false or misleading information.

We are coming up on the one year anniversary of equity crowdfunding.  It is still very early in the equity crowdfunding world to see where the liability issues will shake out.  However, it is clear that the SEC and the state securities regulators take these liability issues seriously, and the issuers and platforms should too.

Equity Crowdfunding. Missing Category: Liability
Equity Crowdfunding. Missing Category: Liability