This article has been written by Vandana Singh pursuing a Diploma in US Corporate Law for Company Secretaries and Chartered Accountants and has been edited by Shashwat Kaushik.
It has been published by Rachit Garg.
Table of Contents
Introduction
An early-stage start-up company needs capital to build the idea or the product, which is often very challenging. These companies rely on raising funds through:
- Loans from banks;
- Debt instruments like Convertible Notes;
- Investments through angel investors/ Venture capitalists in the form of:
a. Debts which includes debentures (CCD) or Convertible Notes (CNs), and
b. Preference shares (CCPS).
While CCPS or CCDs/CNs are the most preferred instruments of securities, they have their nuances and challenges. Angel investors are looking for easier and less time-consuming investment routes. One such investment model is SAFE notes.
What is a SAFE note
The word “SAFE” stands for Simple Agreement for Future Equity. A SAFE note is an instrument/ agreement issued by early start-ups to raise funds in their initial seed stage from individual angel investors. SAFE is a legal contract that entitles investors to receive a company’s equity securities contingent upon certain events, such as subsequent rounds of funding.
One can access the sample here- (https://www.sec.gov/Archives/edgar/data/1777274/000121390020033888/ea128838ex3-1_oraclehealth.htm)
Why SAFE notes
At the early stage of a start-up, it is difficult for the company to project costs/ revenue and assign value to its business. Revenue projections and valuations form an essential requirement for raising funds by way of the issue of securities. The start-up has to undergo the complicated process of due diligence and respond to the information requests of the investor/ their legal team. The founders, the company, and the investor need to enter into a complicated shareholder agreement and negotiate various terms of agreement, which is a time-consuming process. Hence, the founder is unable to focus on the business needs of the start-up while he is involved in fundraising activities.
Additionally, taking on debt can complicate the start-up life cycle, and the start-up may collapse due to financial pressure to adhere to deadlines and pay back loans and interest. In such a scenario, SAFE notes act as a convertible security note- a simple, easy, and fast fundraising agreement that requires no pre or post-money valuation without maturity dates.
A SAFE note is a financial instrument and is mostly used by people whose businesses are at an early stage. Investors find SAFE notes attractive as they allow them to invest in a business without losing any equity. These notes are also very flexible, as they allow the investor to choose the amount they want to invest and the date on which they want their money back. One of the main advantages of SAFE notes is that through them, companies can raise money quickly. Through traditional fundraising methods, companies have to negotiate with each investor individually, which can be very hectic and time-consuming but through SAFE notes, companies can raise money from many investors in a short span of time.
Difference between convertible notes (CNs) and SAFE notes
Convertible notes are designed as debt instruments that convert into equity based on the conditions in the agreement. The start-up may be required to repay the amount in case of failure of subsequent series funding.
SAFE notes are not debt instruments. It allows the investor to convert the SAFE notes into equity at a future funding round. SAFE notes are automatically convertible on the occurrence of specified liquidity events viz. next pricing/valuation round, dissolution, merger/acquisition, etc.
Difference between convertible preference shares and SAFE notes
Convertible preference shares are shares that can be easily converted into equity shares and have certain rights allotted to the investor. Under the CCPS route – CCPS is issued to the investor on the following terms as agreed between the company and the investor;
- The company’s valuation is fixed;
- Director/ observer to be appointed on the Board;
- Reserved matters which require specific consent of the investor;
- Founders’ shares are locked in for a few years and no transfer of shares of founders can take place without the investor’s approval;
- Investors will have “tag along and drag along” rights;
- In the event of liquidation, the investors will have a preference over the founders;
- The investors insist on anti-dilution rights and down-round protection;
- The investors get voting rights in proportion to their investment;
- Receive MIS/ financial information from time to time;
- If the founder, himself or through his relatives, has given any loan to the start-up, the start-up cannot repay the loan until the investor exits.
As a result of the above process, the investor is under tremendous pressure to complete and adhere to the agreed requirements, which impact the business’s day-to-day running.
On the other hand, under the SAFE note route- a simple agreement is entered into with the investor to receive equity shares contingent upon certain events, such as a subsequent round of funding. The company is not bound by the terms as usually agreed in the case of CCPS. The founders can focus
Advantages of SAFE notes to start-up
The advantages of SAFE notes to start up are:
- SAFE notes do not rely on the valuation of the start-up. For an early-stage start-up, a concrete/ factual valuation cannot be done due to the absence of ample data. So, it’s almost impossible for founders and investors to agree on a valuation.
- SAFE note is a simple 5-page agreement. It cuts down on expensive lawyer’s fees.
- It takes 2-3 weeks to conclude the transaction.
- The founder can focus on his business rather than worrying about the complicated process of execution of Shareholders agreements (SHA).
- The founder will not be required to deal with the complex terms of SHA.
- The founder is not required to dilute his stake in the company.
- Unlike other investments, SAFE notes do not require much negotiation.
- SAFE notes end up on a company’s capitalization table.
- Investors can change their investment into equity later.
- The company has complete freedom with no specific expectation because of a lack of pre defined terms.
- There is no need to have an investor director on the Board; thus, management remains in the hands of the founder.
How do SAFE notes benefit the investor
SAFE notes benefit the investor in the following ways:
- Until the valuation round, the stake of investors does not dilute.
- Investors may get an option to invest at a discounted price for the next round.
- Start-up founders are more comfortable dealing with angel investors willing to invest through SAFE notes. This way, angel investors can enter the right company by quickly closing the deal.
Issues with SAFE notes
- SAFE notes, being more straightforward instruments to enter with the investors, lack protection for the investors, which makes it risky for them. SAFE investors do not have any shareholder’s rights which makes them a puppet in the hands of founders.
- SAFE notes can remain outstanding indefinitely, preventing the investor from realising any gain on the investment. In case the company fails to close a funding round, the SAFE investment will remain stuck with the company until it is wound up or liquidated. Upon liquidation, investors may receive up to their original investment back only if the company has enough assets to liquidate after paying off its debts.
- Though the SAFE note agreement is a simple-to-execute instrument, it does not surpass the need for legal consultation. The founders need to understand the complicated mechanics of the Contract. Otherwise, it can lead to non-compliance issues.
- The founder needs to be careful while issuing SAFE notes to multiple investors. This can result in a significant diminishment of equity in the hands of founders. By the time they go for the next round of funding, they have far less equity than anticipated.
- Also, issuing SAFE notes to multiple seed investors can lead to initial investors holding substantial investments in the start-up. The company may find it difficult to raise funds through other series making it difficult to scale up the business. The founders and the SAFE note Investors may get struck and may have to wind up the company to release their investments.
SAFE notes in India
To comply with applicable Indian laws, SAFE note takes the legal form of compulsorily convertible preference shares (CCPS), which are convertible into equity on the occurrence of specified events. In India, iSAFE was pioneered by 100X.VC in July 2019. iSAFE stands for India’s Simple Agreement for Future Equity. Like an option or warrant, an iSAFE note allows the investor to buy shares in a future priced round.
Many start-ups issue iSAFE notes by entering into an iSAFE agreement with the investor. iSAFE notes carry a non-cumulative dividend @ 0.0001%.
Types of SAFE agreements
- Fixed conversion at a future date: SAFE is converted into equity at a future date to be decided.
- Valuation cap; no discount: Higher the valuation cap, the better it is for the founder as it will result in lower dilution of the equity for the founder provided the founders are confident to close the next round of funding at a much higher than the valuation cap;
- Discount, no valuation cap: There is no valuation cap applicable. However, a discount is offered to the investor in the next round of funding.
- Valuation cap with discount: Both a valuation cap and a discount are provided to the investor based on terms agreed upon with the founders and the investor.
- MFN only (most favoured nation), no valuation cap, no discount: An MNS clause allows the investor to elect to inherit more favourable terms offered to any subsequent investor before the next equity round. This is done to bring all investors at par with each other.
Conclusion
In this article, we have explained the overview of SAFE notes, the advantages they offer to start-ups, founders, and investors, the challenges they may face, and the precautions to be taken to mitigate the risks. Though SAFE notes are simpler, easier, and more cost-effective (in terms of legal fees) and don’t have the same level of cumbersome rules that other types of securities have, they still do have their risks and challenges. The start-up needs to carefully evaluate the fundraising process, as any wrong move can jeopardise the growth plans of the company.
Therefore, it is advised that companies consult legal advisers who have worked in the start-up and early stage business ecosystems and then decide on ways of funding, keeping in mind the legal compliances.
- The founder is not required to dilute his stake in the company.
- There is no need to have an investor director on the board; thus, management remains in the hands of the founder.
References
- https://www.upcounsel.com/safe-notes
- https://fastercapital.com/content/What-are-SAFE-notes-and-how-do-they-work-for-startups.html
- https://www.contractscounsel.com/t/us/safe-note
- https://kruzeconsulting.com/safe-notes/
- https://buildd.co/funding/safe-note
- https://www.indinero.com/blog/what-you-gain-and-lose-by-using-safe-notes/
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