Is a SAFE a Security? An Explanation Under Law

Simple Agreements for Future Equity (SAFEs) are a popular financing tool for startups. These instruments offer a streamlined approach for early-stage companies to secure capital, providing flexibility for founders and investors. A key question is whether a SAFE is considered a “security,” as this classification triggers specific regulatory obligations and investor protections, impacting how companies raise funds and how investors participate.

Understanding Simple Agreements for Future Equity (SAFEs)

A SAFE is an investment contract between a startup and an investor. Unlike traditional debt instruments, SAFEs do not accrue interest or have a maturity date, distinguishing them from convertible notes. An investor provides funds in exchange for the right to receive equity at a later date, usually upon a triggering event like a future financing round or company acquisition.

SAFEs offer a less complex and more flexible method for startups to raise seed funding. This mechanism helps avoid the intricate negotiations and legal costs often associated with traditional equity financing or the debt-like characteristics of convertible notes. SAFEs allow companies to defer a precise valuation until a later, more established funding round.

Key SAFE features include a valuation cap and/or a discount rate, benefiting early investors. A valuation cap sets a maximum company valuation for equity conversion, ensuring investors receive shares as if the company was valued at or below this cap, even if a future financing round occurs at a higher valuation. The discount rate allows the SAFE investor to convert their investment into equity at a lower price per share than new investors in a future equity round. These provisions compensate early investors for increased risk.

Core Principles of Securities Law

The legal definition of a “security” under U.S. federal law is broad, encompassing a wide array of financial instruments. The Securities Act of 1933 and the Securities Exchange Act of 1934 define a security to include traditional assets like stocks and bonds, and “investment contracts.” This broad definition captures various schemes designed to attract capital from investors.

The Supreme Court’s 1946 decision in SEC v. W.J. Howey Co. established the Howey Test for determining what constitutes an “investment contract.” This test defines an investment contract as a transaction involving four elements. All four elements must be present for an arrangement to be classified as an investment contract and a security.

The Howey Test involves four elements:
An investment of money. This means an investor has furnished some form of valuable consideration, which extends beyond just cash to include other assets.
A common enterprise. This means the fortunes of the investor are intertwined with those of the promoter or other investors, creating an interdependence where the success or failure of the investment is collectively determined.
An expectation of profits. Investors typically engage in these transactions with the objective of realizing a financial gain or return on their investment.
Profits derived solely from the efforts of others. This means the investor does not actively manage or control the enterprise but rather relies on the managerial or entrepreneurial efforts of the promoter or a third party for the success of their investment.

How SAFEs Align with Securities Definitions

SAFEs consistently demonstrate the characteristics of an investment contract under the Howey Test. The first element, “an investment of money,” is met as investors provide capital directly to the startup. This financial contribution is the foundational act of entering into a SAFE agreement.

The second element, “a common enterprise,” is satisfied because the investor’s financial success is tied to the startup’s overall success. Funds from multiple SAFE investors are pooled, and the future value of their equity depends on the business’s collective performance and growth. Investors share in the risks and potential rewards of the venture.

The third element, “an expectation of profits,” is inherent in a SAFE. Investors anticipate future equity will be worth more than their initial investment, reflecting increased valuation. Valuation caps and discount rates further underscore this profit expectation, as these terms are designed to provide a beneficial conversion price for the investor.

Finally, the fourth element, “derived solely from the efforts of others,” is met. SAFE investors do not participate in the startup’s day-to-day management. Their anticipated profits stem from the efforts of the startup’s founders and team, not from their own active involvement in the business operations. Therefore, SAFEs are considered “securities” under federal and state securities laws.

Issuing SAFEs Under Securities Regulations

Since SAFEs are classified as securities, companies issuing them must adhere to federal and state securities regulations. Offerings must either be registered with the Securities and Exchange Commission (SEC) or qualify for an exemption. Exemptions are a more practical path for most startups, as registration is complex and costly.

Common exemptions for SAFE offerings fall under Regulation D (Reg D) of the Securities Act of 1933, specifically Rule 506. This rule allows companies to raise capital without full SEC registration, provided they meet specific conditions. Both Rule 506(b) and 506(c) permit issuers to raise an unlimited amount of money.

Rule 506(b) offerings prohibit general solicitation or advertising. Under this rule, a company can sell to an unlimited number of “accredited investors” and up to 35 non-accredited investors. If non-accredited investors are included, they must be sophisticated, possessing sufficient knowledge and experience in financial and business matters to evaluate the investment’s merits and risks. Specific disclosure documents must also be provided.

In contrast, Rule 506(c) offerings allow companies to broadly solicit and advertise their securities. This flexibility requires all purchasers to be accredited investors. Companies utilizing Rule 506(c) must take reasonable steps to verify the accredited status of their investors, which often involves reviewing documentation such as tax returns or bank statements.

Regardless of the Rule 506 subsection used, companies must file a Form D notice electronically with the SEC within 15 days after the first sale. The Form D provides basic information about the company and the offering.

Beyond federal regulations, companies issuing SAFEs must also consider state “blue sky” laws. While federal exemptions like Rule 506 preempt state registration for the securities, states can still require notice filings and collect fees. These state-level requirements vary, but typically involve submitting copies of the Form D and other state-specific forms.