Investment vehicles refer to any method or instrument by which individuals or companies can invest and hopefully earn positive returns or interest.
With the growing and evolving startup ecosystem, a variety of investment vehicles are offered, each with their own risks and benefits to suit specific markets, different investment motivations, specific financial goals, or liquidity preferences. Convertible notes, SAFEs, and SAFTs are the latest variants offered by many startups to raise funds for different motives.
Although the investment vehicles primarily share a common/similar objective, it is the different characteristics of these vehicles that define the area of utilization of each investment vehicle. To better understand what each vehicle stands for in the startup ecosystem, the motives for creation, mechanism of operation, legitimacy in different scenarios, and scope of application of each investment vehicle should be thoroughly discussed.
- SAFE aims to simplify the process of raising capital by eliminating some of the drawbacks of convertible notes, such as the time required to draft and negotiate the complex terms of the agreement.
- The framework, SAFT, allows a startup to obtain funding for its blockchain project in a manner that is compliant with existing U.S. federal securities laws and is intended to allow utility tokens created in connection with the blockchain project to be put into service without falling under the definition of a security.
- Different jurisdictions may have different legal implications for the sale of SAFTs and the continued exchange of the underlying tokens.
1. A 'Simple' Alternative to Convertible Note: the "SAFE"
A SAFE or a "Simple Agreement for Future Equity" is an agreement developed in Silicon Valley by Y Combinator that promises investors a future equity stake based on the amount invested if certain triggering events occur, such as a merger/acquisition of the company, an agreed conversion period, or a future equity financing (known as Next Equity Financing or Qualified Financing), usually led by an institutional venture capital fund.
Motives for development
SAFE was developed to reduce the complexity around convertible notes in terms of the timing and nature of the conversion. Most importantly, it aims to create a simpler and shorter version of the convertible note to help entrepreneurs obtain investment without having to negotiate complex terms at length.
Although SAFEs are recognized as derivatives of convertible notes, they differ in certain features. Unlike the convertible note, SAFE is a convertible security that does not represent debt. Therefore, unlike the convertible note, SAFE has no maturity date, meaning that SAFE remains outstanding for an indefinite period of time until a triggering event occurs. For example, if the triggering event is determined to be the 'acquisition of the company' and the company may never be acquired by another company, the conversion of SAFE can never be triggered. SAFE also does not contain accruing interest due to its debt-free nature, which means that investors only receive the right to convert their SAFEs into equity at a lower price than investors would receive in a subsequent financing (based on the discount, the valuation cap in their SAFEs).
- Mechanism of operation
Following the execution of SAFE, the holders of SAFE are obliged to provide funds to the company, while the transfer of equity occurs at a later date and is usually linked to an agreed triggering event.
The SAFE does not provide governance rights, and since the typical SAFE does not contain restrictions on dividend payments, a start-up can pay dividends to its shareholders bypassing the holders of SAFE, and a holder of SAFE is not in a position to control such decisions. Therefore, reviewing the terms of SAFE before making an investment decision is crucial.
In contrast to the disadvantages mentioned above, one of the main advantages of SAFE is that both investors and startups have the option to postpone the valuation to a later date when more metrics are available to value the company, so that the startup does not end up selling more shares than it had intended.
- Legitimacy of SAFE
The tax treatment of SAFE is not entirely clear and the answer probably depends on a case-by-case assessment. The SAFE is likely to be considered a security under the US federal securities laws. Therefore, a startup can only offer and sell the SAFE instrument (i.e. a private investment vehicle) to investors who meet certain income or net worth thresholds to participate in the investment offering in different jurisdictions. In the case of the U.S., there are different qualification levels to be able to invest in a private investment vehicle, such as an 'accredited investor' or a 'qualified purchaser'.
- Scope of application
SAFEs were designed and developed to allow investors to quickly invest in a fast-growing startup without burdening the startup with the more cumbersome negotiations that an equity offering can entail. In addition, the various mechanisms of the SAFE, from the triggering events to the conversion terms, have been designed to work best in the context of a fast-growing startup that is likely to need and attract additional capital from venture capitalists.
The SAFE is likely to be useful when an investor is given the opportunity to participate in a founding round of a fast-growing startup that has the potential to be acquired later, and both parties are seeking to avoid costly negotiations on the terms of the agreement. Although SAFE is a stand-alone offering, it is important to understand the company's disclosures about the SAFE it is offering, as well as the terms set out in the actual agreement, before entering into SAFE.
2. A ‘Simple’ Framework that Strives to Enable Compliant U.S. Token Sales: the “SAFT”
In the wake of the exponential growth of blockchain projects and the U.S. Securities and Exchange Commission's (SEC) and Canadian Securities Administrators' (CAS) view that tokens and token offerings could be securities, the startup ecosystem has felt the need for ways to ensure compliant token offerings.
From the commonly used tool SAFE, a SAFT or "Simple Agreement for Future Tokens" was developed in October 2017 in collaboration with Protocol Labs, Cooley LLP, and numerous investors, lawyers, and token holders (also known as the "SAFT project"). The SAFT project is announced as the development of a rules-compliant framework that seeks standardized terms for rules-compliant investments in tokens, thereby addressing existing regulatory issues with the funding through the issuance of tokens.
At SAFT, accredited investors receive the right, usually at a discounted price, to fully functional utility tokens whose functionality would be implemented at some point in the future, while developers receive the funds necessary to fulfill their project roadmap and improve their project.
SAFTs thus constitute investment contracts and therefore fall under the US federal securities laws and all related implications. However, it is critical to note that although the SAFT itself is subject to securities regulation, the tokens that are distributed to investors once the associated platform is completed should not be securities if the intention is that they can be traded on a secondary market.
- Motives for the development
As detailed in our article on the dual token economy, there is an ongoing debate as to whether token offerings are securities offerings under the US federal securities laws. The impetus for the SAFT structure is the fact that there is no blanket or unambiguous rule that determines which types of tokens are securities and which are not.
SAFTs were based on the legal theory that although SAFT itself is a security sold to investors in a private placement exempt from registration requirements, the tokens, once generated, are not securities depending on their intended use.
The creation of SAFT was intended to separate the token from any pre-launch determination of whether or not the token is a security. Therefore, the legal theory here is that it is the SAFT that is sold with the 'expectation of profit', not the underlying utility token. However, it should be noted that the SEC and courts have held in several cases that SAFTs’ underlying tokens were securities in the first place. Although SAFTs are intended for token sales, this may not be the best option for some tokens. Therefore, a clear vetting of the underlying tokens should be done before issuing them through the sale of SAFT.
- Mechanism of operation
The framework of SAFT will be useful as an instrument that allows accredited investors and other investors to enter into an agreement to acquire tokens, whereby the investor pays the issuer the full amount of the subscription funds up front, and the issuer agrees to distribute the tokens to the investor upon completion of the network at the time of its launch.
Like SAFEs, SAFTs are offered and sold to accredited investors as an investment to fund the development of a startup or project. In parallel to SAFE, at SAFT an investor is entitled to a certain number of tokens upon the occurrence of a certain event (usually the launch of the network). However, while a SAFE offers equity in exchange for an investor’s early-stage investment, the SAFT comes with a promise to provide functional future tokens at a fixed price to be delivered to the investor once the developer’s proposed blockchain project is operational. In most blockchain projects, the investor receives documentation showing that in return for their purchase of SAFT, the investor will receive access when a cryptocurrency is created.
Since SAFT, like SAFE, is a non-debt financial instrument, investors who buy a SAFT face the possibility of losing their investment and having no recourse if the project fails. The SAFT only gives investors a financial stake in the company, which means that investors are exposed to the same investment risk as if they had bought a SAFE.
Under SAFT, once the network is operational, the developers create the tokens and deliver them to the investors, who are then free to trade the tokens on a secondary market to make a profit. The developers can also sell the tokens to the public via an ICO at this stage, as it is now a utility token. It is important to note that the underlying token must be a fully functioning utility token in order for SAFT to be used effectively and fully comply with US federal securities law.
According to SEC Commissioner William Hinman, "once offered in a securities offering, a token may later be offered in a non-securities transaction, depending on the circumstances." However, the tokens that are ultimately delivered to the accredited/authorized investors should be fully functional and therefore not securities under the US federal securities laws. Outside the U.S., the need to restrict SAFTs or tokens to accredited investors will depend on the laws of the local jurisdiction.
The SAFT framework is currently only available to accredited or authorized investors. Unlike an ICO, it therefore excludes retail investors or the general public. The SAFT framework has been developed under, and is subject to, the regulation and impact of the US federal securities laws.
Although tokens issued through the sale of SAFT tend not to fall under the security classification of SEC, it has yet to be officially confirmed by SEC that the SAFE framework actually works as intended. According to Marco Santori, the creator of the SAFE project, the initial whitepaper of the SAFT project was the first step towards a compliant token sale system. But that does not mean SAFT is ready to serve as a standard.
Finally, the tax status of SAFT is unclear - it could be that tax authorities treat the proceeds from the sale of SAFT at the time of sale rather than at the time of conversion, triggering income tax in the year the SAFTs were sold to investors (unless carried forward), rather than in the year the conversion takes place.
- Scope of application
The idea for SAFT relates to a specific class of "utility tokens" that serve as a medium of value for the purchase of goods or services on a distributed network platform. The SAFT framework is not suitable for all tokens. Rather, SAFTs are tailored to developers offering "utility tokens" or "user tokens" for use in connection with their blockchain projects.
Utility tokens can be used, for example, to purchase computing power in a distributed computing facility or storage space in a distributed file storage platform.
Although SAFT can be used to sell tokens to accredited investors under the Reg D exemption, additional documents and steps are required to fully comply with the U.S. securities law.
All in all, with the dramatic growth of the ecosystem, different investment vehicles are being developed to meet the specific needs of investors, startups, or regulators, with their respective advantages and disadvantages.
As startups familiarize themselves with SAFEs, there are still important aspects to consider, such as tax implications, securities registration, and meeting the criteria for accredited investors or authorized purchasers. The risk of SAFT, on the other hand, lies not in the contract of SAFT, but in the fact that the tokens are securities when issued, which would drastically limit their value for the operation of a network. The holders of SAFT would become token holders and should be able to trade tokens on a secondary market without restrictions, as these tokens are no longer "securities". However, through several cases, tokens sold as utility tokens to holders of SAFT have been classified as securities after their issuance by the SEC, which usually leads to undesirable legal consequences.
Therefore, both investors and startups should consider the characteristics of the underlying token when raising funds through the sale of SAFT and navigate the complex analysis of the circumstances underlying securities law.
Please also bear in mind that you must comply not only with US securities law, but also with the securities laws of other jurisdictions in which you offer your securities tokens. Even if the SAFT can be used in the US, it may not be a correct and applicable document in other jurisdictions.