Understanding SAFE Notes Under Regulation D of the SEC Act
Simple Agreements for Future Equity (SAFEs) have become a popular method for early-stage startups to secure funding without immediately issuing equity. However, it's important for both issuers and investors to understand how these financial instruments are viewed under the Securities and Exchange Commission (SEC) rules, particularly Regulation D and other SEC exemptions. This question came up for a client recently, so it seems like a good opportunity to blog about it.
What Are SAFE Notes?
SAFE notes are investment contracts between a startup and an investor, designed as a simpler alternative to convertible notes. Under a SAFE, the investor provides capital to the startup in exchange for the rights to obtain equity in the company at a future date, usually triggered by a specific event such as an equity financing round, a sale, or an IPO. Unlike convertible notes, SAFEs do not accrue interest and do not have a maturity date. One significant advantage to SAFE notes are that the company does not require a valuation, since the SAFE note is based on how much is invested, not on the value of the shares. The share price and company valuation can be determined at a future date. This arrangement paves the way for friends and family investors, or angel investors, to invest smaller amounts at the pre-seed stage, and then benefit from a VC firm’s later valuation. It also prevents the possibility early investors overpaying or underpaying for shares.
While its true that SAFE notes themselves are very easy to prepare. It is important to understand that SAFE notes are still viewed by the SEC as a security, and is thus subject to SEC regulation, as well as state blue sky laws.
Regulation D and SAFE Notes
Regulation D of the Securities Act of 1933 is a set of rules that provides exemptions from the registration requirements for certain private placements of securities. This regulatory framework is critical for startups and investors utilizing SAFE notes, as it often governs the issuance of these financial instruments.
There are several key provisions within Regulation D that are relevant to the issuance and investment in SAFE notes:
Rule 506(b) allows issuers to raise an unlimited amount of capital from accredited investors (and up to 35 non-accredited, sophisticated investors) without public solicitation or advertising. Issuers must provide detailed disclosure documents to non-accredited investors.
Rule 506(c) permits issuers to openly solicit and advertise their offerings, provided that all investors in the offering are accredited investors and the issuer takes reasonable steps to verify their accredited status.
SAFE notes issued under these exemptions must comply with the specific requirements of Regulation D, including restrictions on solicitation, investor accreditation, and filing requirements with the SEC.
Understand that there are other exemptions as well. But as this is meant to be a short post, the true takeaway here is that SEC compliance is a requirement for SAFE note issuances.
Is the SEC likely to kick down your door and raid your office if you offer Uncle Kenny a SAFE note for $5,000 when he invested in your company at launch? Probably not. But, when Uncle Kenny’s SAFE note is inherited by Cousin Steve, and Cousin Steve needs cash and wants to know why he can’t get his money back, it is helpful to know that you have complied with all relevant laws when you issued the SAFE note. It’s also a good look for VC firms you are working with, if they know that your current investors were onboarded correctly.
It is important to remember that at the end of the day, the purpose of getting investments is to build a strong company. Strong companies comply with regulations.
Compliance and Considerations
To ensure compliance with Regulation D when issuing SAFE notes, startups must adhere to several important considerations:
Investor Accreditation: Startups must have a reasonable belief that all investors meet the criteria for accreditation, especially under Rule 506(c) offerings.
Form D Filing: Issuers must file a Form D with the SEC after the first sale of securities, providing essential details about the offering.
State Securities Laws: In addition to federal regulations, issuers must be mindful of the securities laws in each state where investors reside, which may require additional filings or compliance measures.
Information Rights: While not a requirement of Regulation D, providing information rights to investors can foster transparency and confidence, particularly for non-accredited investors involved in a Rule 506(b) offering.
Conclusion
SAFE notes offer a flexible financing tool for startups, but their issuance is not free from regulatory scrutiny. Compliance with Regulation D is essential for legally raising capital through SAFE notes, protecting both the startup and its investors. As with any legal financial instrument, consulting with legal counsel knowledgeable in securities law is advisable to navigate the complexities of Regulation D and ensure that all regulatory requirements are met.
This blog post provides a general overview and should not be considered legal advice. Each situation is unique, and the legal landscape is subject to change. For specific advice regarding your circumstances, set up a consultation with us to discuss. You can fill out our intake form HERE.