Should Indian Startups Raise Funds through SAFE Notes?

Simple Agreement for Future Equity (“SAFE”) notes were introduced by Y Combinator in 2013. Since then, SAFE Notes have been used by startups raising seed funding. SAFE is an agreement between an investor and a company which gives a right to the investor to claim future equity in the company. The advantage of a SAFE note is that the valuation of the startup doesn’t have to be done at the time of the initial investment. The investor receives future equity shares at the occurrence of a priced round of equity financing, dissolution event or liquidation event.

In India, SAFE notes take the legal form of Compulsorily Convertible Preference Shares (“CCPS”) as governed by sections 42, 62 and 55 of Companies Act, 2013 (“the Act”) read with Companies (Share Capital and Debentures) Rules, 2014 and Companies (Prospectus and Allotment of Securities) Rules, 2014. While there are advantages for the startup raising funds, they are not frequently used in India due to the drawbacks for the investors. However, they are gaining traction in India as well.

Benefits of Using SAFE Notes

§ Faster closing of transactions: SAFE notes are simpler and shorter than agreements for subscription of convertible notes with no pre-determined maturity date. Unlike other methods of investment, SAFE notes do not have much room for negotiations. Typically, only the valuation caps are negotiated.

§ Operations flexibility: The simplicity and absence of pre-defined terms and maturity date provides flexibility to the startup to pivot to different models and raise funding as and when necessary, since there is no specific milestone or defined exit period. Generally, SAFE investors do not join the board of the startup, so there is more operational flexibility for the founders.

Drawbacks of Using SAFE Notes

§ Risks: There is a chance that the investment will never convert to equity since future round of funding is uncertain. Also, SAFE notes will rank lower than debt in case of a liquidation.

§ Lower returns: As SAFE notes do not accrue interest, the startup may not be incentivized to close future rounds of equity at the earliest as it can use that capital without paying interest.

§ Regulatory Constraints: Venture funds registered in India are required to exit from their investments within a pre-determined time frame. SAFE notes may not be feasible for these funds due to the uncertainty of exit.

Types of SAFE Notes

There are various types of SAFE Notes that can be issued by a startup to investors. Some of the SAFE notes used in transactions are discussed below:

1. Fixed Conversion at a future date: The investor invests a particular sum of money and the company commits a particular percentage of equity to the investor.

2. Valuation Cap, no discount: In these types of SAFE notes, there is an upper limit on the valuation of the firm in the next round but there is no floor cap and no discount is offered to the investors. The higher the valuation cap, the better it is for the founders as it will result in lower dilution of equity for the founder but provided founders are confident to close the next round at higher than the valuation cap.

3. Discount, no valuation cap: In these SAFE notes, the investor only negotiates the discount for the next round and leave the valuation discussion for the future as that is discussed in pricing round.

4. Valuation cap and discount: In this type, the investor agrees on both the discount and the valuation. Here, the discount is applied to the pre-money cap of the pricing round.

5. Most Favoured Nation (“MFN”) clause: Here, the MFN clause entitles the investors to the same terms as offered to the subsequent investors, so that they will always get the most favourable terms.

Process for Issuing SAFE Notes

We have broadly discussed the process for issuance of SAFE Notes below:

1. Firstly, the Company must be registered under the Act as a private company, and in order to benefit from the exemptions given to a startup, the company should be registered as a startup with Department for Promotion of Industry and Internal Trade (“DPIIT”).

2. The Company should discuss the key clauses of the SAFE Note with investors and agree on the investment terms. The startup should enter into a SAFE Agreement with the investor.

3. The company should conduct a board meeting to approve the issuance of SAFE note and call an extraordinary general meeting (“EGM”) to approve the same.

4. Instead of providing the valuation report with CCPS, the company can issue SAFE note as a rights issue as per section 62(1)(a) of the Act. Alternatively, in case of preferential allotment of convertible securities, the price of the resultant shares (pursuant to conversion) is permitted to be arrived at either: (i) at the time of issuance of the convertible securities, based on the valuation report given at the time of the offer; or (ii) within 30 days prior to the date when the holder is entitled to apply for shares (on conversion), based on the valuation report given no earlier than 60 days from such date.

5. The Company should conduct EGM to approve the issue of SAFE note through special resolution by 3/4th majority. The Company should follow the procedure prescribed for preparing, signing and preparing of minutes of EGM.

6. Within 30 days of passing special resolution, the company should file a certified copy of special resolution with explanatory statement and notice of EGM in Form no. MGT-14 with Registrar.

7. The Company should conduct another board meeting to approve the allotment of shares.

8. The Company should then deliver the share certificates to the investors within two months in accordance with section 56(4) of the Act.

9. The Company should comply with all other applicable requirements for issuance of CCPS by startups.

Conclusion

The startup ecosystem is India is becoming more sophisticated and there are a number of angel investors and micro VC funds that are willing to provide pre-seed and seed funding to startups. At the pre-seed or seed stage, the valuation is difficult since investors are primarily relying on the idea, traction of the product and the reputation of the founders while deciding to invest. At this stage of the startup, SAFE Notes can be considered by both the startup and the investor since the valuation is deferred to a later stage.

This post has been contributed by Ms. Vaneesa Agrawal and Ms. Vasuvita Singh.

[Disclaimer: This article is for academic purpose and is solely to provide readers with general information regarding developments in Indian law. For specific queries, please write to us at admin@thinkinglegal.in.]