Monday, May 17, 2021

How to Raise Funds in India using SAFE Notes?

What are SAFE Notes?

SAFE stands for Simple Agreement for Future Equity, and SAFE notes are a form of convertible security issued by very early start-ups to raise funds in their initial seed stage from individual angel investors. At this stage, it may not be possible to assign a value to the idea or minimum viable product. Thus, with no pre-money or post-money valuation, SAFE notes are an option to raise funds.

It is a contract between the start-up company and the angel investors to issue them equity in the company at a future date at a valuation determined in the future subject to fulfilment of certain conditions with respect to valuation thresholds achieved by the company or capital infusion in a later round by qualified institutional Venture Capital (VC) funds.

Convertible notes are a form of debt till conversion into equity, and may required to be repaid to the investors on maturity if qualified financing is not received in the future. This is an issue for founders as they are uncertain about the future of their start-up. Thus, SAFE notes come as a form of convertible note which is not a debt, but just an obligation to convert to equity on meeting certain conditions in the future.

This form of fundraising instrument was developed in 2013 in the USA by Startup Accelerator, Y Combinator (YC). 

What are the important features of SAFE Notes?

No Interest as Not Debt: These are non-debt convertible securities. They are simpler than the terms of a convertible note which may attract payment of interest till conversion at a particular rate, and other clauses which may deter future equity investors. Thus, SAFE notes don't require payment of any interest.

Simply Drafted & Standard: SAFE Agreements are normally less than 5 pages long, and several usable templates are available online for use by Founders without needing a lawyer to draft such agreements from scratch. Therefore, negotiations using SAFE are also faster unlike other fundraising rounds that take no less than 3-4 months.

Convertible to Equity: They can be converted to equity shares in the future at a discount, which means initial investors may get equity from the start-up in the future at a price much lower at which investors put money in the subsequent rounds.

Discount or Valuation Cap: Convertible securities include a "Discount" that can be used to calculate the value of conversion at a qualified event in the future when they are due for conversion to stock. Whereas, a "Valuation Cap" sets the maximum price that can be used to calculate the conversion price. At conversion, the investors can take advantage of either the discount or the valuation cap, whichever is more favorable to him.

No Valuation: These instruments are issued without carrying out valuation at the time of issuance, as valuation is deferred to future rounds.

Maturity: As it is not debt, there is no specified term of maturity other than conditions for conversion in the future.

Risky for Investors: If the start-up fails, the amount invested may never convert to equity in the future.

Minimal Dividends: Dividends attached to SAFE notes are negligible and notional only.

Lack of Legal Library in India: India does not have enough case laws or easily referable legal library of complications that SAFE notes can bring in the future, or if there is a possibility of regulators in India (specifically the Registrar of Companies or Ministry of Corporate Affairs) taking a stance against them.

What are the Benefits of Raising Capital through SAFE in comparison to a Priced Round?

Any fundraise from investors normally brings with itself a Term Sheet later translated into a detailed Share Subscription & Holders Agreement (SSHA) where investors seek the following rights, none of which are given to investors by raising funds through SAFE.

(i) Pre-Money Valuation, Post-Money Valuation
(ii) Board Seat
(iii) Consent Rights
(iv) Founders' Lock-in
(v) Tag Along Rights
(vi) Drag Along Rights
(vii) Anti Dilution Rights
(viii) Voting Rights
(ix) Debt from Founders' Restrictions
(x) Information Rights
(xi) Creation of ESOP Pool
(xii) Employment Agreements with Founders

The execution costs for an SSHA are huge in lawyer and professional fees, with a timeline of minimum 3-4 months. Therefore, raising funds through SAFE is swifter and inexpensive.

How can SAFE Notes be issued in India?

In India, the VC Fund 100x VC has popularized iSAFE, known as India SAFE. It takes the legal form of Compulsorily Convertible Preference Shares (CCPS) which carry a non-cumulative dividend of 0.0001%, and preference over equity investors at the time of liquidation.

As per the open source agreements drafted by, iSAFE notes are automatically convertible into equity on occurrence of any of the following specified liquidity events 
(i) next pricing or valuation round;
(ii) dissolution, merger or acquisition, etc.;
(iii) at the end of 3 years from date of it’s issue.

Any subsequent issue of iSAFE may be done at rights pari-passu to existing iSAFE holders.

If the investment fails, the investor can book a capital loss on the shares by selling them at negligible cost and utilize that capital loss to offset other capital gains.

What process is to be followed for issuing iSAFE?

The investor and the startup agree on the investment amount. On completion of negotiations, an iSAFE agreement is signed, post which secretarial formalities such as those involved in issue of CCPS are initiated including:

- Amendment of Authorized Capital in the MOA
- Alteration of AOA to include raising of funds through private placement and/or preferential issue of preference shares
- Holding of Board Meeting and EGM to approve the amendment and proposed issuance of CCPS
- Filing of MGT-14, SH-7
- Receipt of funds in a separate bank account
- Filing of PAS-3, drafting of PAS-4, etc.

The preference shares are issued at par, thus there is no premium, and therefore no valuation required from a registered valuer.

The outstanding iSAFE note would be referenced on the company’s cap table like any other convertible security such as a warrant or an option. In the next round which is priced, the iSAFE CCPS will convert to equity as per the agreed terms and the cap table will be finalized through the SSHA. Once the SSHA is in place, it will override the iSAFE.

What are the Types of iSAFE Note Agreements?

(i) Fixed Conversion at Future Date: A pre-defined percentage of equity holding is committed to the Investor at a future date

(ii) Post Money Valuation Cap, No Discount: Say the investor invests Rs. 2 crores at a valuation cap of Rs. 20 crore. Then, if the next round is priced at a post-money value of Rs. 25 crore, the dilution and conversion to equity for the iSAFE investor is capped at 10% being 2/20.

(iii) Discount, No Valuation Cap: If the next round is valued at pre-money value of Rs. 10 crores, and the discount agreed is 20%, then an iSAFE investor of 2 crores will convert at 2/8 i.e. 25% equity. There is no valuation cap.

(iv) Post Money Valuation Cap with Discount: A mix of both the above options built in the same instrument. Discount applies only to pre-money value.

(v) MFN Only (Most Favored Nation), No Valuation Cap, No Discount: Allows the iSAFE investor to accept the most favorable terms as applicable to the subsequent investor.