[By Kumar Shubham]
The author is a student of the National Law University, Odisha.
INTRODUCTION
Early-stage firms or startups today have a variety of fundraising options. Over the years, hybrid investment vehicles such as Convertible Compulsory Debentures (“CCD”) and Compulsory Convertible Preference Shares (“CCPS”) have grown in popularity for raising funds. However, these firms have also ventured into new investing options, which have so far proved viable for both the companies and the investors. Simple Agreement for Future Equity (“SAFE”) & India Simple Agreement for Future Equity (“iSAFE”) are two such methods that have been prevalent in the investment paradigm.
This article analyses the legal landscape surrounding investments through SAFE & iSAFE in India, and draws comparisons between the two. Further, the article provides how iSAFE transactions are beneficial and outlines suggestions for proper implementation of the same.
SAFE & iSAFE INVESTMENTS
SAFE was first proposed by American startup incubator Y Combinator. It was introduced as a better alternative to Convertible debt. It is a financing contract between a startup and an investor that grants the investor the right to acquire equity in the firm subject to specific activating events, such as a future equity fundraising (known as a Next Equity Financing, often led by an institutional venture capital (VC) fund). No maturity date or interest is accrued for SAFEs prior to a conversion event.
The Indian venture capital firm “100X.VC” introduced a significantly modified version of the SAFE concept, i.e., the iSAFE. iSAFE is recognized as Compulsorily Convertible Preference Shares (“CCPS”) in order to maintain the transaction’s legality under Indian law. It is therefore regarded as a commitment to provide investors with CCPS. When the maturity period expires or if another event specified in the terms and circumstances occurs, CCPS, which are preference shares, are converted into equity.
Legality of iSAFE & SAFE in India
Since SAFEs are neither equity/preference shares, debt, convertible notes, nor any other type of instrument, they are not legally recognized in India. SAFE agreements can’t be categorized as “debt” because they don’t accrue interest or have a maturity date. Likewise, it cannot be referred to as “equity” because there are no dividends or other shareholder rights. This greatly reduces the instrument’s reliability and security, which is the primary cause of its failure in India.
However, iSAFE is legally recognised as Compulsorily Convertible Preference Shares since there is no particular statute for such convertibles in India. Sections 42, 55, and 62 of the Companies Act of 2013 as well as the 2014 Rules for Companies (Share Capital and Debentures) and Companies (Prospectus and Allotment of Securities) regulate CCPS in India. Moreover, given that only registered companies may issue shares, the Companies Act of 2013 requires that the start-up be formed as a company before it may issue an iSAFE. As a result, an LLP or partnership firm cannot issue iSAFE notes.
For accounting iSAFE notes in India, neither the accounting standards nor the Institute of Chartered Accountants of India have provided any precise guidelines. The iSAFE notes in India must be listed under the Preference Share Capital heading nonetheless, as they bear the legal designation of CCPS. These will eventually be listed on the balance sheet under the “Shareholder Funds” heading. Moreover, there is no explicit guidance on the taxation of iSAFE Notes in India because the concept of iSAFE is still relatively new here. However, Section 47(xb) of the Income Tax, 1961 can be examined because iSAFE notes are regarded as CCPS. This provision states that any conversion of a company’s preference shares into equity is not recognized as a transfer. As a result, there is no tax due when iSAFE notes are converted to equity.
Comarative Aanalysis & Suggestions
A SAFE note with a valuation cap can serve as a cap for the upcoming financing round and, in essence, functions as an anti-dilution clause. Additionally, it increases risk for the business. The holders of the SAFE notes will be entitled to assume a far bigger percentage ownership of the firm upon conversion, for example, if the company is valued substantially lower in a subsequent fundraising round than when the SAFE notes were issued. Furthermore, investors find it challenging to declare a default when there is no maturity date.
There may be specific circumstances in which the triggers are not activated and the SAFE is not converted, leaving the investor with nothing, depending on its terms, and notwithstanding the identified triggering events. However, given that iSAFE notes essentially take the shape of CCPS, the likelihood of this happening is extremely remote in cases of iSAFE.
The iSAFE notes issued in India are classed as preference shares under the Companies Act, 2013, which categorizes all share capital as either equity or preference and entitles the holders to a minimal dividend. Unlike the SAFE notes proposed by the Y Combinator, which do not guarantee or confer preference if a liquidity event occurs prior to the conversion date, the iSAFE notes will be entitled to a portion of the proceeds, due and payable to the iSAFE noteholders immediately in preference over the equity shareholders and secured creditors.
Moreover, SAFE cannot be used for inviting foreign investments since the Capital instruments permitted for receiving foreign investment in an Indian company means equity shares, debentures, preference shares and share warrants issued by the Indian company, however, SAFE being a future equity, does not suffice the criteria of capital instruments as required under RBI regulations. Therefore, since iSAFE takes the form of CCPS in India, it will help the companies in easily accruing international funding through Foreign Direct Investment routes. The company needs to fill the FCGPR form while issuing CCPS/CCD to an individual/body corporate residing out of India. The Reserve Bank of India (RBI) issues Form FC-GPR when the Company receives a foreign investment and allots shares to a foreign investor in exchange for that investment. The Company is then required to file information regarding that share allotment using Form FC-GPR.
iSAFE is actually just CCPS with a different brand name. The distinguishing feature of iSAFE is that investors can only evaluate the business when it has reached a certain milestone; there is no valuation at the time of investing. There are a few issues with the iSAFE, such as the value cap, which benefits investors but is utterly against the interests of the inventor since investors can obtain a sizable share of equity with only a little initial investment. Due to this, in many cases, some startups opt not to take the iSAFE approach.
Even though iSAFE notes are a relatively new idea in India, start-ups are adopting them more frequently since they help them save a lot of time and money. However, because of the document’s simplicity, it is easy for founders to get carried away. Startup owners must work with specialists like Virtual CFOs to negotiate particular stipulations like valuation caps, liquidation preferences, and other terms because iSAFE will ultimately result in a dilution on the cap table (at the time of conversion). Although iSAFE is a straightforward form that is growing in popularity, it is advised that startups hire professionals to negotiate the investor-friendly conditions.
Benefits of using iSAFE notes in India
An iSAFE provides investors with a number of advantages:
- The cap table is not diluted until the pricing round (or an early conversion) occurs.
- It takes less time to complete the transaction—at least a few weeks less. This is because recording a SHA takes less time because there are several iterations involved.
- The holders of the note continue to receive preference over the founders and other equity shareholders in the event that the startup fails. They are given a greater claim to any funds still in the startup, which enables them to at least partially recoup their initial investment.
Here are some advantages for startups:
- The iSAFE notes do not earn interest because they do not fall in the category of It has no effect on the startup’s debt-to-equity ratio if it eventually raises venture debt.
- The startups will save a lot of money by not hiring attorneys to draft intricate SHAs.
Concluding Remarks
The definition of iSAFE notes, its many effects, and its accounting, taxes, and compliance elements have all been covered in this article. A growing number of angel investors and micro VC funds are eager to offer pre-seed and seed capital to startups in India, where the startup ecosystem is still developing. At the pre-seed or seed stage, valuation is challenging because investors are generally deciding to invest based on the idea, product traction, and founders’ reputations. Since the valuation is postponed to a later point, both the company and the investor might consider iSAFE Notes at this stage of the business.
Although they are still in nascent stage in India, their use is expected to grow as a result of the increased willingness of investors to give startups pre-seed and seed capital since they offer benefits including a straightforward agreement structure and delayed valuation. However, regulators must examine the financial literacy component of iSAFE notes.