The topic of are SAFEs securities under federal or California Securities Laws has been garnering attention in the legal, investment, and business startup worlds, with many questioning the status of SAFEs under established securities laws.

Many legal experts agree that SAFEs should be considered securities under both federal and California law, however, some believe SAFEs are a way for a startup to raise capital without the need for securities exemption filings with the Securities and Exchange Commission or the California Department of Financial Protection and Innovation.

Many founders of startups resist classifying SAFEs as securities because securities filings are often complex and burdensome, which can consume significant time and resources; two things most startups are chronically short on.

In this article, we discuss the subject, shedding light on the complexities of SAFEs and their status under both Federal and California securities laws. We hope to provide clarity for investors, startups, and legal professionals alike.

Understanding SAFEs

Before delving into the question of whether SAFEs are considered securities under Federal or California securities laws, it is important to understand SAFEs.

Simple Agreements for Future Equity (SAFEs) are a popular financial instrument used by startups to raise capital in their early stages. SAFEs are not debt instruments or traditional equity investments, but rather a contractual promise to the investor of the right to future equity in the company under certain conditions, typically a future financing round or the sale of the company.

The key advantage of SAFEs over other funding mechanisms is their simplicity and flexibility. They do not require setting a valuation for the startup or determining a maturity date, making them less complicated and potentially less costly than other forms of startup financing such as preferred equities or convertible promissory notes.

However, it is important to note that while SAFEs offer simplicity and flexibility, they also carry potential risks given their speculative nature and the fact that they bear no interest or dividends until conversion into equity occurs.

Applicable Securities Laws

Applicable Federal Securities Laws

The primary federal securities laws that apply to SAFEs are The Securities Act of 1933 and The Securities Exchange Act of 1934. Both acts encompass a wide range of financial instruments, including SAFEs, and dictate the rules and obligations that issuers must abide by when offering and trading securities.

The Securities Act of 1933

The Securities Act of 1933 primarily governs the issuance of securities by companies, which includes the initial offer and sale of securities. It mandates that companies disclose significant financial and other information to the public, ensuring investors receive comprehensive information about securities offered, and thus, prevent fraud and deceit in sales.

The Securities Exchange Act of 1934

The Securities Exchange Act of 1934 primarily regulates the trading, purchase, and sale of these securities. The Securities Exchange Act of 1934 also established the Securities and Exchange Commission, which is responsible for enforcing securities law and regulating the securities industry under federal law.

Applicable California Securities Laws

California Corporate Securities Law of 1968

The California Corporate Securities Law of 1968 is the central set of blue sky laws governing the offering and sale of securities in California. Its primary aim is to protect investors against fraudulent and misleading practices in the issuance and sale of securities. It achieves this by imposing registration and qualification requirements with the California Department of Financial Protection and Innovation for securities offered or sold in the State of California unless an applicable exemption exists.

Definition of a Security

Definition of a Security Under the Securities Act of 1933

Under the Securities Act of 1933, known better as the Federal Securities Act, a security is defined broadly to include a wide range of investment vehicles.

The Federal Securities Act states that a security includes, “…any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a security, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”

Definition of a Security Under the Securities Exchange Act of 1934

The Securities Exchange Act of 1934, often referred to as the Federal Securities Exchange Act, provides a similar comprehensive definition of a security as the Securities Act of 1933. It encompasses a wide array of financial instruments, including those that are not traditionally considered securities.

According to the Federal Securities Exchange Act, a security is, “…any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘security’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”

Definition of a Security Under California Blue Sky Laws

Under the California Corporate Securities Law of 1968, a security is defined in a broad and comprehensive manner, similar to federal securities laws.

According to California blue sky laws, a security encompasses, “…any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”

Is a SAFE a Security Under Federal Securities Laws and California Blue Sky Laws?

A SAFE is likely to fall under the broad definitions of a security provided by both federal securities laws and California blue sky laws.

As a contractual agreement between an investor and a company, the investor provides capital to the company in exchange for rights to future equity, whether in the form of preferred stock, common stock, membership interest, or an interest as a limited partner. The nature of a SAFE agreement as an investment contract, and the expectation of profit derived from the efforts of others, aligns with the criteria set forth by the Supreme Court of the United States in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), which decision provided the landmark Howey Test for identifying a security.

Therefore, it is reasonable to conclude that a SAFE likely qualifies as a security under both federal and California law. Please note, that this is a general interpretation and for a definitive conclusion, one must consider the specific terms of the SAFE and the context of the transaction. Before deciding whether or not a SAFE is a security, consult with an experienced securities attorney.

How to Treat a SAFE as a Security Before Issuance

Since it is unlikely for a startup to choose to register a SAFE with the Securities and Exchange Commission or qualify a SAFE with the California Department of Financial Protection and Innovation due to the complex and time-consuming nature of these processes, our focus here will shift to the more common and practical approach: understanding the requirements for exemption filings under both California and federal securities law.

Securities and Exchange Commission Safe Harbor Exemptions

Rule 504 and Rule 506 of Regulation D under The Securities Act provide safe harbors that exempt certain offerings from registration.

Safe Harbor Exemption Under Securities and Exchange Commission Rule 504

At the time of this writing, under Rule 504 an issuer can offer and sell up to $10 million of its securities in any 12-month period. An issuer looking to take advantage of this exemption is not required to offer any specific disclosures to the investors, however, the securities when issued are restricted and may not be resold without registration or an applicable exemption.

Safe Harbor Exemption Under Securities and Exchange Commission Rule 506

Rule 506, on the other hand, provides for two distinct exemptions.

Rule 506(b) allows an issuer to raise an unlimited amount of capital from an unlimited number of accredited investors and up to 35 non-accredited investors provided that no general solicitation is used in the offering and certain information is provided to the non-accredited investors, usually in the form of a Private Placement Memorandum.

Rule 506(c) permits an issuer to broadly solicit and generally advertise the offering, but requires that sales be restricted to accredited investors and that the issuer take reasonable steps to validate the accredited status of accredited investors.

Filing Requirements for Safe Harbor Exemption Under Securities and Exchange Commission Rule 506

For both Rule 504 and Rule 506, an issuer needs to file a Form D with the Securities and Exchange Commission prior to or within 15 days of the date of the first offer or sale of securities in the offering. This form includes the names and addresses of the promoters of the issuer, its executive officers and directors, and details about the offering. As a best practice and to avoid complications arising out of filing delays, it is highly advised not to offer or sell any security until after a Form D is successfully filed.

California Limited Offering Exemption Notice Filing

In California, an issuer can issue exempt securities under the California Limited Offering Exemption, often referred to as the “25102(f)” exemption, or the “25102(n)” exemption. Both exemptions require the filing of a Limited Offering Exemption Notice.

The California Limited Offering Exemption Under Section 25102(f)

Under California Corporations Code Section 25102(f), a company is allowed to sell securities to up to 35 non-accredited investors and an unlimited number of accredited investors, provided there is no general solicitation or advertising of the securities. All investors, whether accredited or non-accredited, must have a preexisting personal or business relationship with the issuer, or the managers or controlling persons of the issuer. The issuer must also reasonably believe that all non-accredited investors, either alone or with a purchaser representative, have the ability to protect their interests in the transaction.

California’s Limited Offering Exemption – 25102(n)

The California Corporations Code Section 25102(n) exemption, on the other hand, is similar to the federal Rule 506 in that it allows for the sale of securities to an unlimited number of accredited investors and up to 35 sophisticated non-accredited investors (investors that have the knowledge and experience in financial and business matters to evaluate the risks and merits of the investment). Unlike the 25102(f) exemption, however, general solicitation is allowed if sales are made only to accredited investors.

Notice Filing Requirements for 25102(f) and 25102(n) Exemptions

For both exemptions, a Notice of Transaction Pursuant to Corporations Code Section 25102(f) or 25102(n) must be filed electronically with the California Department of Financial Protection and Innovation prior to or within 15 days of the date of the first offer or sale of securities in California. As with filing a Form D with the Securities and Exchange Commission, the best practice to avoid complications arising out of filing delays is to not offer or sell any security until after a Limited Offering Exemption Notice is successfully filed with the California Department of Financial Protection and Innovation.

Filing of Form D with the California Department of Financial Protection and Innovation for Rule 506 Offerings

For Rule 506 offerings, Form D needs to be filed with the California Department of Financial Protection and Innovation. The form is typically required to be filed within 15 days of the date of the first offer or sale of securities. It is important to note that this filing requirement exists irrespective of whether the securities are sold to accredited or non-accredited investors. As with filing a Form D with the Securities and Exchange Commission, or a Limited Offering Exemption Notice with the California Department of Financial Protection and Innovation, the best practice to avoid complications arising out of filing delays is to not offer or sell any security until after the Form D is successfully filed with the California Department of Financial Protection and Innovation.

Getting Assistance with Securities Exemptions

Securing the appropriate securities exemptions is a crucial part of a successful funding campaign. Our seasoned securities attorney is well-versed in both California blue sky law and federal law and is available to handle all the complexities of securities exemptions.

From filing a Form D with the Securities and Exchange Commission to securing a Limited Offering Exemption Notice with the California Department of Financial Protection and Innovation, we ensure a smooth transition at every step of the process. If you’re considering issuing SAFEs to investors, let our expertise work for you. Reach out to us to streamline your securities exemption process today.