[Devansh Parekh and Tanishq Mohta are BLS. LL.B. students at the Government Law College, Mumbai]
When early-stage companies set out to raise capital, they are often presented with multiple fundraising vehicles to accomplish their goal. Over the years, hybrid instruments for investments such as Convertible Compulsory Debentures (“CCD”) and Compulsory Convertible Preference Shares (“CCPS”) have become very popular. Indian startups have benefitted from record-high funding activities in the past few months. This trend has been noted across all sectors, both by value and volume. While CCD and CCPS are considered to be the most popular investment instruments used in India, some investors are now looking out for new investment routes that have proven successful in the global market. One such method is investing through a Simple Agreement for Future Equity (“SAFE”) notes.
This post seeks to analyze the legality of SAFE notes and its variations in India as well as outline comparisons with the regulatory regime in other jurisdictions.
What is SAFE exactly?
SAFE was introduced by Y Combinator, an American startup accelerator, as an alternative to convertible debt. SAFE is a type of deferred equity legal contract that entitles investors to receive a company’s equity securities contingent upon certain events such as subsequent rounds of funding. SAFE has also become popular because they do not accrue interest while outstanding and have no maturity date. It also helps to create a standardized term sheet between startups and investors while postponing decisions about valuation, liquidation inclinations, and participation rights until later-stage rounds of financing while still allowing the opportunity to raise capital. Initially, investors were uncertain about these novel notes, however, in recent years they have become increasingly popular for investing in startups. These are also called note-alternative securities i.e., contractual rights to purchase the equity shares of the company at a future date. However, the conversion price would be decided on a later date, depending on the valuation of the company, which does not accrue interest. SAFE has often been termed akin to warrants, but warrants have a fixed conversion price.
SAFE notes in India
SAFE notes are automatically convertible into equity shares, either on the occurrence of specified liquidity events such as the next pricing or valuation round, dissolution, merger, or acquisition; or at the end of three years from the date of issue, whichever is earlier.
SAFEs are merely a promise of equity shares on a future date and do not provide an immediate right to the investor until the triggering event has taken place and the note is converted. Further, a SAFE note investor will have no rights to the assets of the company in case liquidation occurs before the note has been converted to equity shares as is in the case of CCPS, and they do not receive a fixed dividend or interest as opposed to CCD.
SAFE notes have multiple variations. In India, to comply with existing laws a variation of SAFE has emerged called the iSAFE notes (Indian Simple Agreement for Future Equity) notes. iSAFE has taken a legal form of CCPS as governed by sections 42, 62, and 55 of the Companies Act, 2013 read with Companies (Share Capital and Debentures) Rules, 2014 and Companies (Prospectus and Allotment of Securities) Rules, 2014 although with certain distinctions. One of the major distinctions is that unlike CCPSs, pre-money and post-money valuation is not required for the issuance of iSAFE. An iSAFE note is a convertible security that is not debt and therefore does not accrue interest. Since the Companies Act, 2013 classifies all share capital as either equity or preference, iSAFE notes issued in India are classified as preference shares and entitles the holders to a nominal dividend. Similarly, unlike the SAFE notes as propounded by the Y Combinator, which does not guarantee or confer preference if there is a liquidity event before the conversion date, the iSAFE notes will be entitled to receive a portion of the proceeds, due and payable to the iSAFE noteholders immediately in preference over the equity shareholders and after secured creditors.
SAFE notes can be considered as contingent contracts that are governed by section 31 and section 32 of the Indian Contract Act, 1872. According to section 31 of the Indian Contract Act, “a contingent contract is a contract to do or not to do something, if some event, collateral to such contract, does or does not happen.” The essential elements that form a contingent contract are: (1)It should be a conditional contract and that condition is of an uncertain nature (2) The contingency contemplated by the contract must be collateral to the contract (3) The contingent event should not be the mere will of the promisor (4)The contingency has to be a condition precedent.
The authors believe that the SAFE notes fulfill these essential elements. Firstly, the conversion of a SAFE to equity is contingent upon a certain condition that is uncertain in nature. Secondly, the contingency is also collateral to the contract of SAFE. Since the contract to invest in a SAFE note already exists but the performance to convert it into equity shares cannot be demanded unless the condition (triggering event) is first fulfilled. Thirdly, in SAFE notes the consideration for contingency is not dependent on the will of any party. The triggers for conversion are pre-determined and are uncertain because the trigger event may or may not occur in the future. Fourthly, the condition which is collateral to the performance of a contract is a condition precedent, that is, it has to be satisfied first and then performance can be demanded. Hence, in the case of SAFE notes, only once anuncertain event is triggered can the investor demand a conversion to equity shares.
Is it really safe?
SAFE provides great flexibility to the capital structures of the start-ups as the sale of equity shares will not cause the note-alternative securities to convert. However, deferring the valuation can have certain negative effects. A SAFE note with a valuation cap essentially has the same effect as an anti-dilution provision and may act as a ceiling for the subsequent financing round. It also creates additional risk for the company. For instance, if the company is valued significantly lower in a subsequent funding round than when the SAFE notes were issued, then the holders of the notes will be entitled to take a much greater percentage ownership of the company upon conversion. Moreover, having no maturity date is troublesome for investors to declare a default.
Since SAFE converts to equity shares based only on some future event, it is important for parties to negotiate what exactly such triggering event for conversion shall be. Depending on its terms and despite the identified triggering events, there may be certain scenarios in which the triggers are not activated and the SAFE is not converted, leaving the investor with anything. Although the possibility of this is very unlikely in the case of iSafe notes, since they essentially take the form of compulsorily convertible preference shares.
In fact, in the United States, in 2016, the Securities Exchange Commission (SEC) entered the fray and reported that the acronym ‘SAFE’ is misleading for retail investors, especially in the context of crowdfunding. The SEC noted that if several small businesses do not attain the ‘trigger valuation’ then it could lead to an unattractive alternative for several investors. The purpose of SAFE was to enable companies to raise successful financing from institutional venture capitalists. If the trigger event does not take place, then the agreement would be left outstanding in perpetuity without providing any substantial return to the investors. A company that wants to issue a SAFE-like security could instead issue a convertible note, which is similar to the SAFE in certain aspects, but which offers retail investors other protections that are associated with debt instruments. Subsequently, the SEC, in 2017, released a notice to caution investors against the downside of SAFE.
Over the past decade, several advances in the field of technology have intrinsically altered the avenues in which startups have operated and funded. The convertible note as an instrument has become more complex and is now commonly used to provide seed funding to these companies. A company must be incorporated to use SAFE notes in the USA. Another significant expense associated with SAFE Notes is the 409A valuation that will help determine the exercise price that must be at or above fair market value. The Internal Revenue Service can hold a company liable for federal penalties if it does not have the 409A valuation.
Although SAFE notes are at a very nascent stage in India, with the increased willingness of investors to provide companies with pre-seed and seed funding, the use of such instruments will increase since it provides advantages like simple agreement structure and delayed valuation. But regulators will have to take a look at the financial literacy aspect of SAFE notes. It would be interesting to see how the regulators come up with rules and regulations for SAFE that are especially contingent contracts in case of any disputes arising out of the conditional event or the valuation. Unfortunately, the lack of industry insight, experience, and technical understanding on the part of the investors, who are now the core decision-makers, makes SAFE notes a risky alternative. The various covenants of SAFE notes like the triggering events and the conversion price are subject to the discretion of the company offering such SAFE notes. Also, the parties would have to firmly negotiate to determine the triggering event for the conversion of debt to equity and other provisions of the SAFE like dissolution/exit rights, voting rights, etc. A definitive way for a company to issue SAFE-like notes would be to issue a convertible note that is akin to SAFE but that offers the investors other protections or covenants that are associated with debt instruments.
– Devansh Parekh and Tanishq Mohta