UNDERSTAND THE UNIQUE PROVISIONS OF SAFE NOTES TO ENSURE YOU ARE CHOOSING THE BEST INVESTMENT OPTION FOR YOUR STARTUP
WHAT IS A SAFE NOTE AND DOES IT MAKE CROWDFUNDING SAFER?
Currently, SAFE Notes are used primarily within the crowdfunding realm for very new startup companies, but are also emerging in more traditional investment environments. In 2015, the SEC adopted Regulation Crowdfunding, allowing smaller, individual investors to participate in securities-backed crowdfunding. Companies are permitted to raise a maximum amount of just over $1 million through crowdfunding. More recently, the SEC has acknowledged an uptick in crowdfunding and the use of SAFE Notes. The SEC specifically warned against the use of SAFE Notes, however, arguing that they are “anything but simple or safe,” and pointing out the danger in the false sense of safety that the name may bring to even the most seasoned investing veterans.
STARTUPS From the startup’s standpoint, SAFE Notes may seem like a viable alternative to the more traditional option of convertible notes. Unlike convertible notes, SAFE Notes do not accrue interest and do not have a maturity date. SAFE Notes are not meant to function like debt and most companies will not carry these securities on their books as debt. Without the looming pressure of debt repayment with additional interest, the company can simplify how it structures seed investments and more readily plan for its financial future.
On the other hand, startups should also be aware of the headache that may come with managing a large number of relatively small investors. Unlike convertible notes with maturity dates and interest, the general purpose of SAFE Notes is to gain equity, not repayment. One small misclassification could provide hundreds of small investors with voting control, virtually signaling the end of the company. Although the intent behind creating SAFE Notes was motivated by a desire to eliminate the need for attorneys to review lengthy documents during the investment process, the stakes are simply too high to depend on the standard “safe” form agreement.What may save time and money initially could result in massive expenses down the road.
INVESTORS SAFE Notes also create unique issues for investors. Instead of providing for repayment, SAFE Notes only allow holders to convert their note into equity. In this respect, SAFE Notes function just like convertible notes but with a caveat – the conversion is entirely dependent upon certain triggering events and can only occur in a preferred round. Although the investor has the freedom to choose when to exercise the SAFE Note, there is no guaranteed date of conversion, repayment is not promised, and the required triggering events may never occur. Essentially, your SAFE Note may end up being worthless.
CONCLUSION As existing industries advance and new industries and companies are created, it’s important to recognize that the mechanisms for investing are also changing. While SAFE Notes attempt to address the needs of both investors and companies, they create new challenges and potentially more dangerous consequences for all parties involved.