Imagine that you are running a startup with an amazing idea. At this early stage, all you need is initial investment. Now, one of the important reasons for an investor to invest in a company is its valuation.
However, it’s baseless to assign valuation to such an early stage startup because from the investors perception it’s just an idea in execution or an idea on paper and there will be no meeting of minds on valuation between founder and the potential investor.
Further, the Angel investors, VCs execute highly one sided agreements with the founders which takes a lot of time and the execution cost of such agreements is huge. Moreover, the founders stay unaware of most of the terms of these agreements due to lack of knowledge of complex terms and their consequences.
Here comes an agreement which is extremely simple, inexpensive, favorable to the founders and can be executed real quick.
SAFE
A Simple Agreement for Future Equity (“SAFE”) is an agreement for raising funds by a startup company from investors by providing them in return the right in future equity of the startup. It is one of the easiest ways for an early-stage company to raise funds.
SAFE in layman’s language
The two most common methods of raising money are debt (loan) and equity (ownership). Now, being an early stage startup, loan will require it to pay regular interest and issuing equity shares will cost it ownership/ decision making rights. And none of the options are in favour of the startup.
Therefore, SAFE is an alternative way of seeking investment in the startup in which it promises the investor certain shares at a future stage. And this way the startup will neither be required to pay interest nor it will lose ownership rights.
SAFE in India – applicable laws
SAFEs were introduced in 2013 by an American technology startup accelerator named Y Combinator. At the time of its introduction, startups and investors were primarily using convertible notes for early stage fundraising.
In India, SAFEs are not legally recognized because it is neither an equity/ preference share nor debt, convertible note or any security. Therefore, a slightly modified concept of India Simple Agreement for Future Equity (“iSAFE”) was introduced by an Indian VC firm “100X.VC”.
To keep the transaction legal as per the Indian laws, iSAFE is recognized as Compulsorily Convertible Preference Shares (“CCPS”). Hence, iSAFE is considered as an agreement to issue CCPS to investors. CCPS are the preference shares which are converted into equity at the expiry of the maturity period or any event prescribed in the terms & conditions. These are reflected in the Financial Statements of the company under Shareholders Fund.
Therefore, iSAFE are governed by Sections 42, 55 and 62 of the Companies Act, 2013 read with the Companies (Prospectus and Allotment of Securities) Rules, 2014 and Companies (Share Capital and Debentures) Rules, 2014.
Prerequisite for iSAFE
Considering that iSAFE are issued as CCPS, the startup entity must have been incorporated as a Company as per Companies Act, 2013 because only a company is allowed to issue CCPS.
When iSAFE Notes are converted into equity?
iSAFE investors are issued iSAFE Notes which, upon trigger of conversion date, are automatically converted into the Equity Shares.
It is apparent that in the case of iSAFE, conversion date is of essence. These are convertible into equity shares on occurrence of either of the specified events viz. next valuation round, dissolution, merger/ acquisition etc.
Is it Debt or Equity?
iSAFE is a neither debt nor equity. There’s no fixed interest on iSAFE, however, for the purpose of legal compliances, iSAFE carries a non-cumulative dividend @ 0.0001%. Further, in case of liquidation of the company, iSAFE Note holders shall get preference over the equity shareholders of the company.
Convertible Notes or SAFE?
Convertible note means an instrument evidencing receipt of money initially as a debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of the start-up company upon occurrence of specified events and as per the other terms and conditions agreed to and indicated in the instrument.
The fundamental difference between an iSAFE Note and a Convertible Note is that the latter is essentially a debt with a specified interest rate and iSAFE does not carry any interest.
Types of iSAFE
Essentially iSAFEs can be issued with either of the following five methods:
1. Conversion at fixed dated
Investors receive equity shares of the company at a fix conversion date and at a fix conversion price.
2. Valuation Cap
Investors fix the maximum valuation price of the company at which their iSAFE notes will get converted. For example:
A. Actual valuation arises at less than the valuation cap
- Investment: iSAFE investor invests 10 cr
- Valuation cap: iSAFE investor fix the valuation cap at 100 cr
- Actual valuation: At the next financing round, company is valued at 50 cr
- Conversion rate: iSAFE investors will get 20% (10cr/ 50 cr) equity in the company.
In this case the investor is compensated for the lower valuation of the startup
B. Actual valuation arises at more than the valuation cap
- Investment: iSAFE investor invests 10 cr
- Valuation cap: iSAFE investor fix the valuation cap at 100 cr
- Actual valuation: At the next financing round, company is valued at 150 cr
- Conversion rate: iSAFE investor will still get 10% (10cr/ 100 cr) equity in the company
This form of iSAFE favors the iSAFE investors. The higher the valuation cap the better it is for the investor because if the actual valuation arises at lower than the valuation cap, the investor will get more equity in the company. Here’s a sample Agreement.
3. Discount
This form of iSAFE favors the Startup founders. There’s no valuation cap. The discount also depends on how quickly the founder is intending to close the deal and can make the discount available for a limited period of time. Here’s a sample Agreement.
4. Valuation cap with discount
It’s a mix of both valuation cap and discount. Here’s a sample Agreement.
5. Most Favored Note (MFN)
In the event the initial iSAFE Note Holder determines that the terms of the Subsequent Convertible Securities issued to subsequent investors are preferable to the terms of its iSAFE Note, the company will provide the similar rights to the initial iSAFE Note Holder. This will bring all the existing and subsequent investors at par. Here’s a sample Agreement.
Can Shareholders Agreement (SHA) and iSAFE both be executed at the same time?
iSAFE is executed for the initial investment in the early stage startup and overcomes the disadvantages of an SHA, therefore, only one of them can be executed at the same time. The ultimate purpose of both SHA and iSAFE is to invest in the company.
Further, iSAFE precedes an SHA. The time when SHA is entered, iSAFE will be terminated and the final terms shall be governed by the SHA.
Conclusion: should your Startup enter into iSAFE?
In reality, iSAFE is nothing but CCPS under a different brand name. The unique characteristic of iSAFE is that there’s no valuation at the stage of investment and the investors can value the company when it has reached a particular milestone.
However, there are a couple of red flags associated with the iSAFE such as the valuation cap which is investor friendly but completely against the interest of the founder because through little investment at the initial stage only, investors can get a huge portion of equity.
iSAFE is becoming popular being a simple 5 page document but it is advisable that Startups engage experts to negotiate the investor friendly clauses.
Comments
Post a Comment