In a well-functioning market, reasonable investors are less likely to invest in companies when they cannot confidently value the opportunity. This presents a serious problem for young startups because they are unavoidably difficult to value. Partly in response to the valuation challenge, specialized startup investors evolved how they contract for young-startup investments. Around 2005 they began using deferred-equity instruments (first convertible notes, and later safes and the KISS). Deferred-equity instruments offer a partial solution to the valuation challenge by allowing specialized startup investors to thoughtfully invest in venture capital-eligible young startups without valuing them at the time of investment. Deferred-equity instruments have become an important financing tool for the traditional startup market and have positively contributed to the United States’ seed financing explosion over the last decade. This article explains how investors value startups, why the task is unavoidably difficult, and how deferred-equity instruments contractually deal with this otherwise intractable problem.
If the story ended there, deferred-equity instruments would be a resounding success. However, they spread to the Regulation Crowdfunding (“Regulation CF”) market in 2016. To assess whether deferred-equity instruments are suitable for the Regulation CF market, this article examined the Regulation CF offerings on three popular funding portals—Republic; StartEngine; and Wefunder—to get an informed picture of Regulation CF deferred-equity offerings. The examination consisted of all the Regulation CF deals funded through those three portals during 2019. The study captured 205 funded deals, of which seventy-one were safe offerings and twenty-two were convertible note offerings. This article provides a detailed look at the issuers conducting Regulation CF deferred-equity offerings and the investment contracts they employ. Based on the study, this author draws several negative conclusions about the Regulation CF deferred-equity market and generally finds these offerings result in an improper risk transfer that is likely to harm public investors. To address the problem, this article recommends that the SEC or FINRA impose a suitability duty on funding portals that host Regulation CF deferred-equity offerings.
Tulsa Law Review
John L. Orcutt, Valuing Young Startups is Unavoidably Difficult: Using (and Misusing) Deferred-Equity Instruments for Seed Investing, 55 Tulsa L.Rev. 469 (2020).