This article originally appeared on CrowdfundInsider
This article is a response to the draft paper referenced in the article entitled “Crowdfunding and the Not-So-Safe SAFE” authored by Joseph M. Green and John F. Coyle. There are many so words to describe my thoughts about the paper: patronizing, impractical, misguided—but mostly, unfortunate.
One might attribute the recommendations of this paper as merely that divide between ivory tower academics and real-world practitioners. However, the paper is unfortunate because it also reflects a very real attitude that make some lawyers known as the “no” (wo)man. Successful corporate counselors, for example, understand that the fastest way to alienate the legal department from the rest of a company—and to become the one department that everyone avoids—is to hand out nuclear ‘nos.’ Instead, lawyers should ask their client “what is your goal?” and work creatively with them to get the end zone in a productive, compliant, and legal manner. Lawyers must understand the nuances of the business, and avoid being the bottleneck that stymies growth, kills innovation, and puts a company out of business. The negative impact of their recommendations should be in line with the severity of the issue. Yet, the severe recommendation proposed by this paper demonstrates a lack of real world understanding of startup investing and crowdfunding, is not measured in impact, and would effectively cripple an entire industry.
In case you haven’t read the paper, here’s a brief summary: the authors of the paper take issue with the use of the SAFE—or Simple Agreement for Future Equity—as a financing instrument in equity crowdfunding. Specifically, they believe that SAFEs are an inappropriate tool to crowdfund capital because they assume (wrongly) that such issuers are “unlikely ever to raise institutional venture capital.” They then discuss three solutions:
1) funding portals should police the usage of SAFEs;
2) funding portals should amend the template SAFEs made available on their website; and
3) funding portals should ban the use of SAFEs by their issuers entirely, and should instead push issuers to use convertible notes or other instruments. Of these three options, the authors believe their third and last recommendation to be the best approach.
In doing so, the authors attempt to use a nuclear bomb when a mere fly swatter will do. (And the fly is imaginary.)
Debunking the Three Recommendations
First, before addressing the assumption that Reg CF issuers are inherently unqualified to obtain venture capital financing, let’s consider each of the three recommendations:
Recommendation #1: FPs Should Police the Use of SAFEs
The authors suggest that “the funding portals could seek to limit the use of SAFEs to the “right” sort of companies—those that are likely to raise future capital from institutional investors.” First, based on personal experience, some funding portals already do. Secondly, even if a funding portal tries to steer an issuer in the right direction, ultimately it is for the issuer to decide the form and terms of its own security, and not the funding portal.
It is not only paternalistic for a funding portal to mandate the type of security being offered, but also legally dubious to do so. The Final Rules of Reg CF, pages 274-278, explain that funding portal may not “curate” offerings, but must apply objective criteria to limit securities offered, provided that the portal “may not deny access to an issuer based on the advisability of investing in the issuer or its offering”—which seems to be the purpose here. Additionally, a funding portal which dictates the terms of an offering would probably be subjecting itself to great liability.
The article also suggests that if funding portals are unwilling to “curate” (or dictate) the form of its issuer’s securities, then the SEC/FINRA should mandate it. It provides the example of certain brokerages’ requirements to obtain certain information from customers to ensure they understand the security they’re buying.
However, the SEC has never adopted a merit-based regime in reviewing securities offerings; instead, it has a disclosure-based regime, meaning that the SEC’s concern centers around disclosure of all risks relating to the security. The authors criticize the SEC for being too laissez faire in the types of securities available to issuers, yet overwhelmingly, the greatest criticism of Reg CF has been the SEC’s prioritizing investor protection over capital formation. Let’s not forget—this regulation came out of the JOBS Act—it’s purpose is to “jumpstart” capital formation for businesses and create “jobs.” None of that is going to happen if the regulation is too burdensome to use effectively.
Recommendation #2: FPs Should Amend the SAFE Templates
Secondly, the authors recommend that “portals could amend the forms of SAFE currently on offer to address some of the specific issues we have raised”—namely, that the SAFEs lack maturity dates and voting rights, do not accrue interest while outstanding, don’t pay dividends for cashflowing businesses, and most importantly, are being used by issuers unlikely to raise capital. I’ll address the last issue later. For all other criticisms, these are simple changes that an issuer’s attorney can make to the documents.
Although issuers may use template documents offered on a portal’s library, it’s the issuer’s ultimate responsibility to decide what terms its willing to offer investors, and to work with its counsel to edit the documents accordingly. Just because the airline stewardess offers you peanuts doesn’t mean you have to eat them. Similarly, just because a funding portal’s library offers a SAFE template doesn’t mean the issuer has to use it. (Can you tell I’m writing this on a plane?)
That said, it’s worth considering why some of these terms might be missing from the templates. For example, consider the lack of voting rights. From the perspective of issuer’s counsel, I would currently advise a client against offering voting rights. Having to collect votes from thousands of $100 investors sets up an issuer for a future governance nightmare. From an investor’s perspective, I would question the issuer’s sanity and sophistication if they did give voting rights. As an investor, I would want the company to concentrate on growing its business and making me money—I would not want it to spend hundreds of hours trying to get and count the votes of thousands of tiny investors. That is a complete and utter waste of the company’s time, and does not result in making me money. That and, assuming that I’m properly diversifying my portfolio, I know that I would lack the details, time, and incentive to vote in any educated manner on my miniscule stake in the company. Figuring out how to limit ongoing administrative burdens is currently one of the most painful points of structuring any security with the crowd is mind. For these reasons, I didn’t mind that one the first Reg CF investments I made used a variation of a SAFE instrument.
Recommendation #3: Ban the SAFE
The third and final recommendation, which the authors adopt, is that funding portals should prohibit the issuance of SAFE instruments on their platforms altogether.The argument against SAFEs centers mainly around the assumption that issuers using the SAFE are unlikely to raise future rounds of institutional venture capital. That assumption is baseless.
On WeFunder, 13 of 35 companies have used the SAFE instrument to date, and have secured roughly $933,000 in commitments of the total $6 million in commitments made on the platform. Of these 13 companies, WeFunder notes that:
- 3 of them (Taxa, Shapescale, & Vet Pronto) are Y Combinator alumni that also raised on a SAFE from professional accredited angel investors.
- 1 of them (Discotech) is a technology startup (but not in YC) that raised on a SAFE from professional accredited investors.
- 4 of them (Voodoo, Kibin, Next-Door, Everpedia) raised from convertible notes from professional investors.
- Only 2 of them have not raised money from professional investors before: Bogobrush and Ohos.
- The rest have raised equity from professional investors, with no dividend rights.
WeFunder CEO Nicholas Tommarello explains the implications of banning SAFEs from Reg CF crowdfunding:
“The highest-quality companies in Silicon Valley—such as YC alumni—raise using SAFEs. If they are not allowed to do so from retail investors, they simply will not crowdfund.”
Limiting the array of financing instruments only aggravates the adverse selection issue; it doesn’t help it.
The limitations of convertible notes
One of the most important decisions a company makes when launching a Reg CF crowdfunding campaign is choosing the proper security. Every type of security has its pros and cons. Oftentimes, issuers I talk to actually want investors to be able to reap a significant return on their investment; the greater problem is the follow-up and management of many investors after an issuer has accepted money from the crowd.
The article suggests that convertible notes are a better alternative to SAFEs because it “accrues interest, has a maturity date and offers retail investors other protections that are associated with debt instruments.” I disagree. The authors seem to think that investors might actually get paid back under a convertible note instrument if the issuer is unable to raise a follow-on equity financing. This couldn’t be further from the truth. Professional investors do not expect their convertible note “loans” to be repaid. If the company is unable to raise follow-on financing, it generally does not survive and will go bankrupt.
In the context of crowdfunding, convertible notes raise certain complications. Explains Tommarello, “generally, if the company is unable to raise the follow-on financing event before the convertible note’s maturity date, it’s customary to get convertible note investors to “amend the note to extend the maturity note (since, otherwise, the startup just goes bankrupt immediately). That’s fine when there’s a dozen accredited investors. That’s not fine when the startup has to track down the signatures of 3000+ $100 investors.”
Missing the Point of the CrowdSAFE
The authors also point out a perceived weakness of Republic’s novel crowdSAFE—that it delays the conversion event of a regular SAFE. They misunderstand though that that’s the entire purpose of the crowdSAFE—the instrument is designed to allow the crowd to invest without making them shareholders, thereby relieving issuers of the many administrative and governance headaches associated with other types of securities. And while there may be outstanding questions about this new instrument, it is undeniably a brilliant product of legal engineering.
Outsmarting the Crowd
Tommarello had the following to say about the article:
“Wefunder supports any security. We have templates for SAFE’s, revenue shares, and loans. We also will upload the security of any company that their lawyer drafted. While we strongly advise companies on the best type of security for their type of business, we believe in the wisdom of the crowd (i.e., the free market) to be the final dictator. That is, we don’t believe a funding portal (or academics) are wiser than investors. Investors are generally smart with their money; if the terms are bad, they don’t invest.”
The remainder of the article make several arguments to attempt to support the ban against SAFES—that retail investors are not familiar with SAFEs or convertible notes (people aren’t born knowing how to invest in stocks either, but they learn); that retail investors won’t be paid dividends if the company turns from an exit-oriented business into a cashflowing lifestyle business (but angels and VCs don’t get that luxury either, and if a startup decides not to exit, they may issue a dividend because it’s the right thing to do a la Kickstarter); that inexperienced retail investors might believe that the SAFE is a safe investment (there are disclosures all over the portal, the Form C; and the checkout questionnaire about the risk of loss); that the costs of crowdfunding are higher than that of traditional startup financing (attorneys are still used in convertible note financing, and they’re certainly not free); and that companies outside of major tech hubs shouldn’t use SAFEs because they won’t be able to raise venture capital from Silicon Valley (there’s an issue with the chicken-and-egg reasoning here since one goal of crowdfunding is geographically diversify the capital raising process; that and I didn’t realize financing instruments should be limited by geography).
If anything, all these arguments sound more like a string of patronizing excuses masked as concern. As Sara Hanks said, investors have an inalienable right to invest in stuff, no matter how smart or how stupid. The nearly $74 billion Americans spent on the lottery last year says so.
The Fix Crowdfund Act
Many of the issues around crowdfunding will be solved if the Fix Crowdfund Act—which passed the House 394-4, and is be voted on by the Senate—gets passed with “exempt reporting advisor” SPV provision added back in. Tommarello predicts the following effects of passage:
“1) Investors will likely have voting rights, as startups won’t mind as long as they only need to get one signature (via the SPV);
2) Convertible notes may be used safely (since startups only need one signature to amend the maturity date);
3) We may get rid of the repurchase and delay to IPO provisions (since this is meant to protect against the possibility of startups being forced to go public after only raising $1 million);
4) The funding portal/exempt reporting advisor and the lead investor are likely to negotiate better terms.”
There are certainly issues today with equity crowdfunding. The current rules significantly hinder issuers from providing investors with greater rights, lest they subject themselves to huge administrative burdens and messy cap tables; the lack of a lead investor that represents the interest of retail investors (and thus lack of arms-length negotiation) leads to inflated valuations and mispriced rounds. However, banning the SAFE is neither a practical nor reasonable solution to address the overarching issues with equity crowdfunding. The article and its recommendations may be well-intentioned, but these aren’t the solutions we’re looking for.