In transaction advisory we are seeing the term 'SAFE' come up more and more. Company founders may have raised or learnt of investment through SAFE notes and want to utilise it for funding rounds locally… and may not be receiving an open welcome to the investment modality. Why? Well, let's strike out the myth first - it is not just because it is not widely used in Bangladesh, but mainly because 'SAFE' instruments are not afforded the safety of being recognised in the relevant companies and securities laws of Bangladesh and therefore falls squarely into the category of a contract, which brings with it the concerns of enforcement.
The goal of this article is to explore what 'SAFE' instruments are and how/what can be done to make it an instrument of choice in our country for early-stage companies.
A Simple Agreement for Future Equity ("SAFE") is an instrument developed by Y Combinator in 2013 for equity financing, which has been adopted widely across jurisdictions (and recently in the Asian regions). SAFEs have come to be considered a potentially transformative tool addressing the gap of 'financing and funding' which is often the major challenge to growth for early-stage companies. The terms and conditions of SAFE agreements determine the relationship between the company and investor regarding equity rights for triggering liquidity events, allowing the parties to delay valuation while providing access to capital. SAFE agreements are meant to convert into company shares when new investors do priced rounds in future, and so there is no impact on the share capital of the company unless the investor receives the shares against her investment.
Why so popular? Initial stages of a company is usually defined by a lack of assets and cash flow, which makes it difficult to arrive at an accurate valuation. SAFEs solve two problems: (1) the valuation conundrum of an early-stage company and (2) time and costs of preparing elaborate investment documents. A SAFE postpones the valuation question so the investor can proceed even if the founder and investor have very different ideas about what the company is worth. This gives the company the advantage of access to immediate funding without locking in a share price. Also, a SAFE is meant to be a short standard document that can be prepared easily and inexpensively.
How does funding work with a SAFE? A SAFE is a cash investment now in exchange for a contract that gives the investor the right to convert the investment into future equity. A SAFE is not a loan: there is no interest rate, no payments and (generally) no maturity date. A SAFE is not equity in the sense that it is not common or preferred shares and does not give any voting rights or other equity rights under our local laws.
Critical Clauses in SAFEs. Aiming to be a simple document, a SAFE instrument typically addresses a handful of critical terms which are integral to such instruments, these being:
i. Discounts/Discount Rate : A SAFE investor is entitled to a percentage discount for the next round of equity financing. A discount rate gives the SAFE investor a discount off what future investors pay for equity at the time of the triggering event.
ii. Valuation Cap : The investor obtains a more favourable price per share in the future by setting a maximum convertible price. A valuation cap has a two-fold advantage: (a) it protects an investor from losing value due to dilution, while (b) limiting the price the investor pays for the company shares.
iii. Triggering Event : SAFEs convert into equity when an agreed-to "triggering event" happens. The typical events are a qualified equity financing, a liquidity event (sale or IPO) or merger, in which case the SAFE investor gets the same type of equity that the future investors get (typically preferred shares).
iv. Pro-rata Rights : With pro-rata rights in the SAFE, the investor can invest extra funds into the company at the time of the triggering event to maintain her percentage of ownership in the company (this term being akin to preemption right built into our Companies Act, 1994). The investor generally pays the new price, and not the original price.
v. Most Favoured Nations (MFN) Provision : This term is applied when more than one SAFE option is being offered to investors. If an investor has invested in a SAFE and the company raises another, the company is required to inform the investor of the terms for the following SAFE. If the investor thinks the new SAFE has better terms than her, she has an opportunity to request the same terms. This is also known as a non-discrimination clause.
SAFE Risks and Challenges. A SAFE instrument is not without its challenges and investors must understand what they are signing up for in making investments through SAFE agreements:
• An early-stage company can change their business model, change their product or service lines and take decisions effecting the business of the company without needing the consent of the SAFE investor. If an investor wants these checks and balances against their investment and a say in the decisions which may eventually affect the value of the investor's stake in the company, then a SAFE instrument is not the ideal choice - the investor should rather consider a direct equity investment through ordinary or preference shares.
• Since a SAFE does not give immediate shares in the company, the investor has no rights in the business assets of the company in case of liquidation, nor fixed dividend. Since these contracts are not regulated by other laws, it is highly risky to invest using this mechanism, given that triggering liquidity events may never happen.
•Since it is merely a contract, it will be governed by sections 31 and 32 of the Contract Act, 1872, namely contingent contracts, and can only be enforced if the contingent event takes place. Thus, there is high-risk potentially for the investor to even reclaim the nominal amount, in case of the non-happening of this event.
• Since SAFE agreements do not have any interest or maturity date, they cannot be classified as a 'debt'. Likewise, due to the absence of dividend and other shareholder rights, it cannot be termed as 'equity' either. Moreover, having no maturity date is troublesome for investors to declare a default.
• There is an ongoing concern in Bangladesh in light of certain central bank notifications, also adopted by the Financial Reporting Council (FRC), that such investments would have to be converted to shares within a predetermined timeframe (within 360 days of receipt of the investment, particularly for foreign investment).
Accounting Treatment. SAFE is generally treated as long-term liability, since it requires companies to deliver an unknown number of shares in the future at a price to be determined later. As a result, definitive numbers cannot be established at the point of investment. In Bangladesh, however, we see SAFEs recorded as share money deposit and therefore a deferred equity legal contract.
The Tax Challenge. The tax regime is set up to handle equity and debt investments. SAFEs are neither. They are a contractual right. This begs the question -- is a SAFE investment a taxable transaction and is the future conversion to equity upon a triggering event a taxable transaction, given that the investment rolls over to future equity?
The Legal Instrument. SAFEs are first and foremost, a contract. In India, a SAFE is usually termed as an 'equity derivative contract' which converts the initial capital invested by the investors into future stock of the company, based on contractual terms and conditions, either on the occurrence of specified liquidity events such as the next pricing or valuation round, dissolution, merger, or acquisition; or at the end of a fixed period from the date of issue, whichever is earlier. SAFE is similar to a warrant with the difference that warrants have a fixed conversion price whereas for a SAFE the conversion price is decided on a later date, depending on the valuation of the company.
In Bangladesh, share warrants are discussed in sections 46 to 51 of the Bangladesh Companies Act, 1994 and have, among others, the following features:
- share warrants may provide for payment of future dividends on the shares or stock included in the warrant;
- the bearer of share warrants are entitled to transfer the warrant;
- share warrants allow for registration of the name of the bearer of share warrants in the register of members of the company, if the articles of association of the company so allow;
- bearers of share warrants are not qualified to become directors of the company.
However, section 46(1) of our Companies Act, 1994 restricts the issuance of share warrants in a private company; therefore, share warrants can only be issued by publicly listed companies in Bangladesh. This problem can be easily addressed by allowing for SAFE instruments to be issued as share warrants in private companies, or by recognising SAFEs as compulsorily convertible preference shares which does not require a valuation-lock and does not require the number of shares to be specified while recognising the holder as a member of the company in the company filings at the RJSC (as has been done in India).
iSAFE or Indian Simple Agreement for Future Equity has become a standardised template agreement. It is regulated by the Company Law as a Compulsorily Convertible Preference Shares ("CCPS") governed by the Companies Act, 2013 {Sections 42, 62, and 55 of the Indian Companies Act.} read with Companies (Share Capital and Debentures) Rules, 2014 and Companies (Prospectus and Allotment of Securities) Rules, 2014 with certain distinctions {One of the major distinctions is that unlike CCPS, pre-money and post-money valuation is not required for the issuance of iSAFE. An iSAFE note is a convertible security that is not debt and therefore does not accrue interest.}. Since the Companies Act, 2013 classifies all share capital as either equity or preference, iSAFE notes issued in India are classified as preference shares and entitles the holders to a nominal dividend. iSAFE note-holders are entitled to receive a portion of the proceeds in preference over equity shareholders and after secured creditors. Upholding the limited liability concept, it is the company and not the founders who are liable to pay-back. On the other hand, it is convertible on the happening of the event in case of success.
As for other jurisdictions, it has been said that the primary reason for the success of SAFE in countries like USA, Singapore, etc. is because there is no interest on a SAFE, unlike a debt instrument or loan. There is also no maturity date or compulsory period of conversion, leaving room for greater flexibility and negotiations. Instead of having terms and schedules, they are based on certain contingent events, the happening or non-happening of which determines the interest of the investor to either: (a) reclaim the invested principal amount or (b) convert the capital into stocks/shares of the company. Furthermore, since a SAFE is a contract and not a security, it allows the investor and the entrepreneurs to negotiate the terms.
Conclusion. Once it receives statutory support, SAFEs could become one of the simplest and cheapest ways to invest in early-stage companies. However, without regulatory recognition (as it stands now), if the SAFE works out to be more complicated or as complicated as the investment itself, it is worth considering whether in fact it is better to follow the tried and tested method of direct investment until the regulatory regime is ready to recognise the rights under what is in Bangladesh till now an innovative legal instrument. To ensure certainty of investment and enforcement, it is important for the regulators, particularly the Ministry of Commerce, the Ministry of Finance and the Bangladesh Securities and Exchange Commission to consider whether it is time for Bangladesh to give its nod to the Bangladesh Simple Agreement for Future Equity (bSAFE), the main considerations being the classification of the investment, whether it would be compulsorily convertible after a fixed period (maturity date), whether the investor will enjoy pro-rata rights, the taxability of the mechanism and some right for SAFE investors to claim liquidation proceeds in case the business goes south.
Anita Ghazi Rahman is an Advocate of the Supreme Court and the Managing Partner of The Legal Circle.
© 2024 - All Rights with The Financial Express
