Fundraising can be one of the most stressful activities for bootstrapped founders. After many pitches, rejections, and moments of general anxiety, you’ve finally landed your first investors and signed your first SAFEs. What are the next steps from a legal perspective?
What is SAFE?
SAFE stand for “simple agreements for future equity.” No shares are issued immediately pursuant to a SAFE; rather, investors invest a certain amount that will be converted into the equivalent number of shares upon an event that leads to a formal valuation of the startup, such as a fundraising round led by an institutional investor, or the sale or acquisition of the startup. While founders can offer investors discounts or other perks that increase the value of their investments upon this valuation, no one knows exactly how many shares an investor will receive when the SAFE is signed.
Public Offering
Whenever securities, which are financial instruments that offer some fungible value, such as shares, options, or bonds, are sold, a public offering must be filed with the Securities and Exchange Commission (the “SEC”). The question is whether SAFEs represent the sale of securities if no shares have been issued. Many founders decide on their own that no public offering is needed, which is a big mistake!
SAFEs represent a promise for the future issuance of shares, even if the exact number of shares is unknown, which makes it similar to a stock option, and stock options are securities. Just because the details of the stock issuance are vague doesn’t mean that no sale of securities is taking place. Eventually, the SAFEs will convert into shares, and this in itself means that SAFEs require the filing of a public offering. While the SEC isn’t on the back of every startup fundraising in the United States, if founders are ever caught having skipped this step, they could be required to pay heavy fines.
So what public offerings are needed?
Types of Public Offerings
Regulation D is a set of laws under the Securities Act of 1933 that regulates the sale of shares. It was enacted after the Great Depression in response to widespread fraud in the financial sector that contributed to the global economic crisis. Regulation D requires stock issuers to disclose information about their companies to increase the transparency of securities transactions.
There are several subcategories of exempt public offerings under Regulation D, such as Rules 504, 506(b), and 506(c). The subcategory that a startup would apply for depends on the type of investors it intends to fundraise from. Generally, investors can be divided into two groups: accredited and non-accredited. Accredited investors have certain financial means, such as an annual personal income of at least $200,000, or business assets of at least $5 million, that render them capable of making sophisticated financial decisions under the law. Non-accredited investors are individuals or entities that don’t meet these qualifications and are deemed to require additional legal protections.
How are the subcategories different?
Rule 504 allows an unlimited number of non-accredited investors to invest in the startup, and permits general solicitation (or, in other words, marketing), but limits the amount of investment that can be raised in any given year to $10 million.
Rule 506(b) allows up to 35 non-accredited investors to invest in a startup but prohibits general solicitation.
Rule 506(c) is limited to accredited investors only but has no limit on general solicitation or the amount that can be raised. Founders should refer to their business plan to see which public offering is the most suitable strategically.
Finally, states may require additional notice filings for exempt public offerings, known as Blue Sky filings. The states in which these filings must be made depend on the investors’ residences.
Navigating Exemptions and Continuing Fundraising
While exemptions under federal or state laws can be made quickly, applying for them can be complicated. There are no requirements that lawyers have to be the ones making these filings, so legally experienced founders can manage them themselves. First-time founders may find it helpful to consult a lawyer to navigate this process and ensure the right exempt public offering is made. In any event, signing a SAFE is not the end of the fundraising process. Founders should ensure that they stay on the right side of the SEC.
