What is SAFE note?
SAFE (Simple Agreement for Future Equity) notes are a simpler alternative to convertible notes. They were created in 2013 by Y Combinator, a Silicon Valley accelerator, and allowed startups to structure seed investments without interest rates or maturity dates. SAFEs are short five-page documents. The valuation caps are the only negotiable details. “In India it is popular as iSAFE note”.
A SAFE note is a convertible security that, like an option or warrant, which allows the investor to buy shares in a future priced round. It addresses many of the drawbacks and challenges posed by convertible notes and can be an equitable option for investors and founders. Startups may prefer SAFE notes because, unlike convertible notes, they are not debt and therefore do not accrue interest (though for legal compliance purposes, iSAFE note carry a non-cumulative dividend @ 0.0001%).
B) iSAFE note:
“iSAFE” stands for India Simple Agreement for Future Equity. To comply with applicable Indian law, iSAFE note takes the legal form of compulsorily convertible preference shares (CCPS) which is convertible on occurrence of specified events.
C) Types of iSAFEs:
Two terms should be discussed before looking into different types of iSAFEs
Discount and Valuation Caps
Convertible securities typically include a discount that can be applied to the future valuation when it’s time to convert. A valuation cap sets the highest price that can be used to set the conversion price. At the time of conversion, the investor can take advantage of either the discount or the valuation cap or both whichever is more favorable. SAFEs can include a discount, a valuation cap, both, or neither.
iSAFE agreement can be executed using any of these following options:
- Fixed conversion at a fixed date where conversion is fixed at future date. (Mostly preferred)
- Valuation Cap, no Discount where an investor negotiates terms relating to valuation cap (Minimum & Maximum value) but no discount allowed.
- Discount, no Valuation Cap where investor can negotiate discount on valuation cap.
- Valuation Cap and Discount where investor can negotiate both valuation cap and discount.
- MFN (Most Favored Note), no Valuation Cap, no Discount: In case another SAFE note is issued, the company will have to tell the initial investor about it. In case the terms of the second SAFE are better for the investor as compared to the initial SAFE, then the investor can ask for the same terms. There will be no Valuation Cap and no Discount.
- D) Conversion period of iSAFE notes:
iSAFE notes are automatically convertible either on occurrence on specified liquidity events viz. next pricing / valuation round, dissolution, merger / acquisition etc.,
E) Points to be remembered:
- Since this is legally Compulsorily Convertible Preference Shares (CCPS), compliances under the Companies Act, 2013 must be followed.
- Multiple iSAFE agreements can be signed with different set of investors.
F) Comparison with CCPS:
Since iSAFE take legal form of CCPS it need not comply with all the terms which are to be complied by CCPS. Following are few comparisons:
- Pre and Post money valuation is not required for iSAFE unlike CCPS holders.
- A short five-page document is sufficient for iSAFE issue instead of lengthy Share Holder Agreement.
- No exit rights to investors of iSAFE note. Only transfer available to iSAFE note holders.
- iSAFE investors do not get voting rights which provides greater flexibility to promoters to atke decisions.
- No Board seat for iSAFE investors unlike CCPS holders.
G) Benefits for Investors:
- No dilution till fixed priced (Valuation) round.
- Can negotiate a discount to the next round with founders.
- Investors can enter right company by quickly closing the deal, as founders feel more comfortable dealing with angel investors, who are willing to invest through iSAFE.
H) Benefits to Start-Ups:
- An iSAFE is neither debt nor equity, and there is no interest accruing.
- If the startup fails, whatever money they have left after discharging other liabilities, will be returned to iSAFE note holders in preference over the equity shareholders until iSAFE note holders receive their investment amount. Such liability is on the company, not on the founder individually. iSAFE is most suited for early-stage startups where valuation is difficult to be ascertained.
- Simple five-page document – No need of expensive lawyers and therefore cost is reduced.
- Time taken to conclude the transactions – 2 to 3 weeks.
- Founder can focus on his/her business and not worry about Shareholders agreement, complex process etc.
I) Subsequent issue of iSAFE:
A company can issue sequel iSAFE after first iSAFE issue, but it is recommended to issue subsequent iSAFE only if it is necessary. It helps the startup in securing a rightfully deserved higher valuation subsequently in a PRICING round (where pre and post money valuations get discussed), when the startup has gained significant revenue / business traction, such that a fair valuation is possible.
J) Liquidation preference:
iSAFE note holders have liquidity preference (to the extent of their invested capital), over Founders / Equity shareholders. First iSAFE note holders will have pari-passu rights with subsequent iSAFE note holders/investors.
K) Valuations requirement:
Early stage bootstrapped companies (Start-ups) are generally either at Idea, MVP (Minimum Viable Product) or Very Early Revenue stage and hence it’s unfair to assign a valuation so early in the lifecycle. iSAFE notes do away with the need to state pre-money or post money valuation, as the equity in favour of iSAFE note holders is issued much later viz. at an equity pricing round, once the start-up has achieved some stable and sustainable revenues.
L) Lock-in period:
Ideally the investment made by the iSAFE sequel note holders shall be subject to lock-in for a period of 1 (one) year from the date of allotment of the iSAFE Sequel Notes, or such other period as prescribed under SEBI (Alternative Investment Funds) Regulations, 2012.
M) Accounting treatment:
Since iSAFE notes take legal form of Compulsory Convertible Preference Shares (CCPS), the authorised capital has to be suitably increased to the extent of the funds raised through the issue of iSafe Notes. Amount received shall be shown under Preference Share Capital as CCPS. The Company should comply with necessary compliances to increase authorized share capital as well as paid-up capital (i.e., filing Forms SH-7 and PAS-3 with ROC) and the amount received against the issue of iSAFE notes will be shown under the head shareholders’ funds in balance sheet.
Since iSAFEs take the legal form of CCPS we now look into tax treatment of CCPS.
As per section 47 (xb) of Income Tax Act, 1961 any transfer by way of conversion of preference shares of a company into equity shares of that company is not regarded as transfer. Hence it does not attract capital gain tax at the time of conversion.
Capital gain taxation arises once the above shares are sold. The difference between the exercise price and price at which it was sold will be the capital gain. Long term and short-term capital gain will be determined based on the holding of the shares for more than 12 months and less than 12 months respectively.
The government has exempted the tax being levied on investments above the fair market value in eligible startups. Such investments include investments made by resident angel investors, family or funds which are not registered as venture capital funds.
M) Procedure to issue iSFAEs under Companies Act, 2013
As iSAFE Notes take the form of CCPS, the capital structure of the company has to be re-classified into Equity & CCPS and also the Authorised capital has to be suitably increased.
Step1: Increase in authorised share Capital and approval for issue of iSAFEs.
- Pass Board resolution for convening EGM and proposing to issue iSAFE notes.
- Pass necessary resolution for increase in authorised share capital and for issue of iSAFE notes in EGM.
- File form MGT-14 within 30 days from the date of EGM.
- File form SH-7 within 30 days from the date of EGM to increase the authorised share Capital.
Step2: Execution of iSAFE agreement
Execute and enter into iSAFE agreement with the investor with the desired terms mutually agreed upon by the Company/promoters and investors.
Step3: Issue of iSAFEs (by way of rights issue):
- Pass Board resolution for rights issue.
- Rejection/Renunciation of rights by existing shareholders and the same shall be issued to investors of iSAFEs.
Note : Suggestive that iSAFEs be issued by way of rights issue in order to skip the valuation requirement.
Step4: Filing of return of allotment to ROC
On receipt of money from the investors company shall file return of allotment in form PAS-3 as if its allotment of preference shares.