Earlier this month, the SEC proposed long-awaited rule changes to Regulation CF. Reg CF (the CF stands for crowdfunding) governs how everyday investors can invest in startups – and how startups raise money through certain SEC-registered investment platforms.
The industry has been asking the SEC to make some of these changes for years. And these changes have the potential to reshape the startup investing landscape. They can also be a source of major confusion. Even well-written SEC regulations can be tough to understand. So we asked our friends at Republic to help us better understand what the SEC is proposing.
Republic is one of our favorite startup investment platforms. The Republic team devotes a lot of time and energy to working with regulators – especially those at the SEC. Republic was in the room with the SEC talking about these changes two weeks before they were published. It also met with the SEC the day after the proposed rule changes were published.
We asked our friends at Republic several questions about the proposed changes via email. Their responses, below, have been lightly edited for clarity.
What changes are the SEC proposing for Reg CF raises?
The SEC is proposing a number of changes:
a. The amount a startup can raise in a 12-month period would be increased from $1.07 million to $5 million.
b. The limits on the amount of money accredited investors can invest in any Reg CF offering (or any deal) would be eliminated, providing the funding portal takes reasonable steps to verify the investor’s accreditation status. (Individuals must demonstrate they have made $200,000 a year for the last two years. Households must show they have made $300,000 a year for the last two years.)
c. Nonaccredited investors would have their investment limit based on the higher of either their net worth or their income. That would raise the investment limits across the board. The current rule calculates investment limits based on the lower of the two.
d. Startups that want to raise money would be able to test the waters, allowing them to see if there is interest in a Reg CF campaign before committing to the legal and financial work to prepare for a fundraising campaign.
e. Arcane advertising rules that make marketing difficult would be eliminated.
f. Bad actor disqualification would extend to a 10-year look-back period for most things, rather than being triggered by whether the act took place before 2016 (this increases the universe of founders that can raise money for their startups).
g. Special purpose vehicles (SPVs) would now be permissible to act as investment vehicles for investors to invest into instead of directly into the issuing company (but the proposal isn’t economically or practically feasible).
Which proposed change do you think is the most significant?
Raising the cap on how much capital startups can raise to $5 million is the most important change. It makes crowdfunding more appealing to bigger companies with devoted user bases looking to raise capital. Many of these larger startups were previously turned off by Reg CF’s small fundraising limits. It also allows companies that are already experiencing success under Reg CF continue to utilize and expand that success.
How do you think this changes how founders approach CF investing?
Founders already like Reg CF. It’s like a marketing campaign that pays you at the end AND provides loyal investor advocates. The changes should significantly expand that effect and make the raise large enough that it’s the only capital formation a startup needs for a single round.
How do you think this changes how investors approach CF investing?
Because startups can raise more money, investors won’t be shut out of well-performing deals.
And the increased investment limits for investors will expand access to investment opportunities.
It’s one thing to say that startups are allowed to raise up to $5 million. But how realistic is it for startups to target a $5 million raise? Do you expect those raises to be the exception or the rule?
That is yet to be seen. But if we look at Reg A+ offerings right now, we might already be there. Right now, many startups that want to raise more than $1.07 million (the most you can raise in a CF offering currently) turn to Reg A+, which allows startups to raise significantly higher amounts of money. Reg A+ offerings are also far more expensive and time-consuming to prepare for. But most of these deals are raising on or about $5 million.
If companies previously using Reg A+ decide to conduct their offerings under Reg CF, there very well could be $5 million raises in the market already.
What percentage of your startups raising under Reg CF are equity, convertible notes and SAFEs (simple agreements for future equity)?
The majority of companies raising on Republic – currently and historically – have used SAFEs. In fact, we have hosted more than 140 offerings. And more than 130 of those have used our Reg CF-specific Crowd SAFE.
First, what are SAFEs? And then please tell us more about the changes proposed toward SAFEs. There is some confusion here.
SAFE is a catchall term for “simple agreement for future equity,” a relatively new investment instrument created by Y Combinator to facilitate easier investment in companies that had not gone through a stock valuation process (because it was premature or not economically rational) and to provide the economic outcomes provided by convertible notes – without the tax and accounting repercussions that reduce value and efficiency for issuers and investors.
Each SAFE is different. But the basic mechanics are that the investor provides a certain amount of funding to the company at signing. In return, the investor receives stock in the company at a later date, in connection with specific, contractually agreed on liquidity events.
The primary trigger for stock delivery is generally the sale of priced shares by the company, typically as part of a future priced fundraising round. Unlike a straight purchase of equity, shares are not valued at the time the SAFE is signed. Instead, investors and the company negotiate the mechanism by which future shares will be issued and defer actual valuation.
These conditions generally involve a valuation cap for the company and/or a discount to the share valuation at the moment of the trigger event. In this way, the SAFE investor shares in the upside of the company between the time the SAFE is signed (and funding provided) and the trigger event.
Republic’s Crowd SAFE builds upon this to reduce operational inefficiencies by locking in the economics at the next financing round but not requiring the company to convert the SAFE until an exit of some kind, such as a sale of all the assets of the company, a change of control or an IPO.
The theory is that before these events occur, holding stock won’t entitle the holder to any meaningful rights. So keeping investors “in” the SAFE doesn’t harm them in any way but does let the company keep a clean cap table, helping it raise future rounds.
What precisely is the SEC proposing to change related to SAFEs?
It hasn’t actually proposed any changes to SAFEs. There was a line in a recent SEC release that suggested SAFEs would not be issuable in Reg CF offerings. But, as we discuss below, we don’t think the line makes sense or is enforceable.
For the sake of comparison, how are SAFEs different from convertible notes?
Unlike a convertible note, a SAFE is not a loan; it is more like a warrant. In particular, there is no interest paid and no maturity date, and therefore, SAFEs are not subject to the regulations that debt may be in many jurisdictions.
This means SAFE holders don’t need to report interest as unrealized gains on their taxes, and companies don’t need to track the debt, which may make it harder for them to leverage their resources to take other loans.
As a result, SAFEs reduce the cost of issuance. Companies issuing convertible notes, the predecessor to SAFE instruments, need to issue tax forms to their investors every year, secure extensions to the convertible notes if a conversion is unideal, and wind up with investors directly on their cap table at times that may be inopportune for a growing business.
Based on the experience of companies using SAFEs on the Republic site, what does the record show? How many SAFEs have been converted into equity? How many are still waiting to be converted? How many were never converted because either the startup had a liquidity event that didn’t trigger a conversion or it simply went under? And do you have an average wait time?
Just to level set, let’s remember the typical triggers for conversion are caused by either a change of control (i.e., acquisition, sale of assets or an IPO) or follow-on qualified equity financing (i.e., raising a follow-on round over a trigger amount, often set at $1 million for early-stage companies). It’s also important to note that the Crowd SAFE, Republic’s proprietary SAFE, doesn’t force conversion at the follow-on financing stage. It also provides investors the right to cash in the form of their principal in certain situations.
Since the inception of Crowd SAFEs, we have seen about 15% of companies utilizing Crowd SAFEs go through a triggering event. And about a third of the startups that reached the triggering event actually looked to convert their Crowd SAFEs into equity. If I had to estimate today, a little more than 50% of Crowd SAFEs will never actually convert to equity.
Are SAFEs a current concern for the SEC? Is it looking at SAFEs closely? Are future restrictions possible?
The commission has been concerned with convertible instruments for a while, mostly because it believes investors are not sophisticated enough to understand them. However, many of the SEC’s concerns are one-sided or suggest a lack of experience with venture financing.
For example, the SEC cautioned investors about SAFEs in this 2017 alert. We actually agree with the SEC that SAFEs are not appropriate for all companies. That’s why we don’t let every company using Republic issue them.
We also believe if a company offering a SAFE is not best suited to using it, the crowd can and should use its discretion to not invest. An investment opportunity is an offer. And if an investor doesn’t like the terms, they shouldn’t deploy their capital.
Has there been feedback from the public to the SEC’s changes that indicate opposition to SAFEs?
Many people have expressed confusion over the SEC’s language. We hope this article and our comment letter to the commission will help reduce that confusion.
Is there a better instrument than SAFEs that could eventually replace them? Is there a model SAFE with the terms and language Republic prefers? What kind of guidance along these lines do you offer to founders?
There is no perfect instrument. Everything in business is about finding a reasonable solution that meets all parties’ needs. We’ve modified the SAFE to best meet Reg CF, and we continue to help companies modify it to meet their offerings’ facts and circumstances.
What’s the most likely timetable for the SEC to officially approve and issue the changes?
Before the recent health crisis, we estimated the SEC would OK the changes during the third quarter of this year. But now, it’s looking more like a fourth quarter thing.
Is this it for a while? Will we have to wait another eight years for the next round of changes?
It’s unclear. The frequency of changes depends on the political climate and how these changes work.
Can Congress still institute further changes? Is any bill making the congressional rounds? What are its chances?
Yes, it can still make changes. But we think that’s unlikely. Despite the fact that the Jobs Act is bipartisan legislation, Congress is highly polarized right now and seems to be focusing on other things.
On a scale of 1 to 10, how would you rate the SEC’s proposed changes?
An 8 is fair. We got the majority of what we wanted, and the things that were not delivered upon are workable.
In your dealings with the SEC, did you get a sense of how it felt about crowdfunding? Was it excitement or concern? Risk or opportunity? A big deal or small deal?
The SEC is supportive. It’s encouraged by the lack of fraud (in the space) and wants to encourage sustainable growth for issuers and investors throughout the country.