07 Sep 2017 Market Terms for SAFE Crowdfunding
A common issue for founders of Silicon Valley startups is finding investors before they have any traction in order to fund the very business operations that will create traction. While founders typically spend a lot of time seeking capital from “angel” investors in order to fund their seed-stage companies, another solution that founders may consider is a federal crowdfunding offering to reach people that the founders do not know personally. Crowdfunding offerings provide founders with an opportunity to raise as much as $1 million during a twelve-month period from accredited and non-accredited investors; however, while crowdfunding was touted as a way to open up the funding process for startups, it actually creates significant disclosure burdens and costs that founders need to understand.
One of the requirements for a crowdfunding offering is that the offering must be conducted through a regulated “funding portal,” such as WeFunder, StartEngine, and FlashFunders. The funding portal will handle many of the details relating to the offering and will generally provide advice to the founders about the investment instrument they should use to raise funds. One popular option is a Simple Agreement for Future Equity (SAFE), which was developed as a startup-friendly alternative to convertible notes. SAFEs have the same conversion features of convertible notes without the maturity date or interest rate that are included in convertible notes. Because they are founder-friendly, SAFEs seem to be more prevalent among “hot” deals where investors are scrambling to be included and have less leverage to negotiate more protections like those normally seen in convertible notes. They were developed to provide a quick and low cost solution to seed-stage financings, and this goal can be accomplished as long as the investors understand what they are buying.
For example, most crowdfunding SAFEs have a valuation cap and a discount rate. This means that either the valuation cap or the discount rate applies when determining the conversion price to be used when converting this form of SAFE into shares of Safe Preferred Stock. The discount rate applies to the price per share of the Standard Preferred Stock sold in the equity financing. If this calculation results in a greater number of shares of Safe Preferred Stock for the seed investor, then the price per share based on the valuation cap is disregarded (and vice versa). Ideally, this will incentivize seed investments by rewarding early investors with the better deal between the two terms as they are defined in the SAFE instrument.
As stated above, the discount rate applies to the price per share of the Standard Preferred Stock sold in the equity financing. The discount, generally between 10% and 30%, will depend on existing market factors and the amount of time that is expected to pass before the startup will reasonably be able to close the equity financing. The most common discount is 20%. The rationale for giving seed investors the benefit of this discounted price is that they typically expect to be compensated for having shouldered more risk than investors in the equity financing (who are investing later).
The valuation cap also determines whether the investor will receive Standard Preferred Stock or Safe Preferred Stock, with the latter being issued if the pre-money valuation for the equity financing is greater than the valuation cap. The rationale for including a valuation cap is to prevent “valuation whiplash” in a scenario where the company uses the proceeds of its seed round to build a business that supports a much higher valuation in the equity financing. Thus, the valuation cap ensures that seed investors still have a meaningful stake in the company if a startup achieves an unusually high valuation in its next round of financing.
While a SAFE is recommended because it “simply” requires negotiation of a discount rate and valuation cap, in reality the valuation cap can be one of the most difficult things for the founders and investors to agree upon. Currently, valuation caps range between $3–5 million on the lower end and $8–10 million on the higher end for seed-stage SAFE financings. When valuation caps are on the lower end of the spectrum, there may be a substantial spread between the valuation cap and the pre-money valuation in the equity financing, which results in an off-market liquidation preference for the SAFE holders.
One of the easiest choices to make is the choice of state law in the SAFE’s governing law provision. The choice of law clause permits the parties to select the state law that governs the SAFE instrument. In general, parties should choose the law of a state that has a relationship to the parties or the transaction (or there should be some other reasonable basis for the choice), otherwise the provision may be unenforceable. For example, the founders may pick a state in which they are located or where the major investors reside. In startup SAFE financings, the parties most often choose the state in which the principal place of business of the company issuing the SAFEs is located.
One of the biggest potential problems with using SAFEs in crowdfunding is that inexperienced investors may mistakenly believe that they are receiving something simple and safe, i.e., a security that all of the top startups and investors in Silicon Valley use, and make an investment without fully understanding the risks that they are assuming by purchasing those SAFEs. As a result, the terms in the SAFE instrument need to be carefully and thoroughly explained to small, unaccredited investors. The Securities and Exchange Commission, in particular, requires that all investors in federal crowdfunding offerings be given adequate disclosures about the structure and terms of the investment.
Moreover, seed-stage SAFE financings are “private placements” under federal and state securities laws and thus must be conducted in accordance with their registration and qualification requirements. Even if the Company qualifies for the crowdfunding exemption from registration, however, certain states require “notice” filings to be filed with that state’s agency when securities are sold to investors who reside in that state. The JOBS Act tries to minimize this burden by preempting state filings for federal crowdfunding offerings unless (1) the state is where the issuer has its principal place of business, or (2) the state is where 50 percent or more of the dollar amount of the offering was issued to investors.
As is the case with most startups, the vast majority of companies raising money through crowdfunding are unlikely to ever raise institutional venture capital. One reason may be that VCs are concerned about unaccredited and unsophisticated stockholders. Another reason may be that VCs are concerned about low quality disclosures that are not vetted by professionals. This may raise fraud issues that can result in large fines or even the rescission of prior issuances. Conversely, the startup may have erred on the side of caution by over-disclosing, and as a result, disclosed too much information to its competitors. This can be a lose-lose situation for most seed-stage companies. Finally, any hiccups with the crowdfunding offering and/or not meeting crowdfunding goals will make the company less attractive generally.
While crowdfunding portals are heavily regulated, the process is very standardized which makes it an attractive option for seed-stage financings as long as the company’s disclosures are well drafted. Aside from making sure that disclosures are adequate, however, the founders must consider other significant risks such as market issues unrelated to the terms in the SAFE and the inability to secure traditional venture financing down the road.
 “Standard Preferred Stock” means the shares of a series of preferred stock issued to the investors investing new money in the company in connection with the initial closing of an equity financing.
 “Safe Preferred Stock” will be a separate series of preferred stock issued in the equity financing, commonly referred to as “shadow preferred” or “sub-series” preferred stock. It will have the same rights, privileges, preferences, and restrictions as the Standard Preferred Stock, other than with respect to: (i) the per share liquidation preference and the conversion price for purposes of price-based anti-dilution protection, which will equal the conversion price; and (ii) the basis for any dividend rights, which will be based on the conversion price.
 This article contains information included in “Seed Capital: A Guide for Sustainable Entrepreneurs,” which is part of “Finance: A Library for Sustainable Entrepreneurs” prepared and distributed by the Sustainable Entrepreneurship Project (http://www.seproject.org) and used with permission granted by Alan S. Gutterman.