Introduction
India’s startup ecosystem has seen a significant rise in venture capital funding. Startups usually secure funding with a variety of options, such as Convertible Notes and Priced Rounds. iSAFE (India Simple Agreement for Future Equity) notes are gaining popularity as a method of early-stage fundraising.
iSAFE were initially created from the Y Combinator SAFE agreements. Their primary advantage lies in helping to sidestep valuation which is a significant hurdle for securing early-stage funding. However, iSAFE contracts remain a double-edged sword in India providing much needed flexibility to startups but at the same time lack clarity due to its untested nature in India’s venture capital and startup landscape.
This blog explores iSAFE contracts, their benefits, and the legal hurdles that they carry.
What is an iSAFE note?
iSAFE notes is a convertible instrument in which a Venture Capital investor makes a cash investment which can be converted into equity at a later date. It was introduced by 100XVC in India which is an early-stage investment firm. iSAFEs take the form of Compulsorily Convertible Preference Shares (CCPS) and are convertible into equity shares on a specified date.
India’s startup ecosystem spans a range of sectors, including Healthtech, Deeptech, Consumer, and Fintech. These startups are usually in the pre-revenue stages, being in an ideation stage or having only developed a Minimum Viable Product (MVP). Estimating a valuation for such a startup is an arduous task. This is where the iSAFEs help with the valuation aspect.
Before delving into how iSAFEs solve the valuation problem, we need to understand two major concepts, which are a priced and unpriced round. A priced round is a round in which the startup has a valuation. An unpriced round is a round in which the startup’s valuation is not determined. In an iSAFE, the valuation of the startup is deferred to a future event. This event could be anything ranging from a Merger, Acquisition or IPO and is known as the triggering event. iSAFEs are contracts that typically contain 5-6 pages. This helps startups secure quicker funding and reduces the need for expensive legal counsel.
Legality of iSAFEs
While there are no specific laws governing convertibles such as iSAFEs, they are indirectly regulated under Section 32 of the Indian Contract Act, 1872, and Sections 42, 55, and 62 of the Companies Act, 2013 read along with Companies (Share Capital and Debentures) and Companies (Prospectus and Allotment of Securities) Rules, 2014.
SAFE notes are considered contingent contracts under Indian law, governed by Sections 31 and 32 of the Indian Contract Act of 1872. A contingent contract is one where performance depends on the occurrence of an uncertain event. The key characteristics of contingent contracts, which SAFE notes fulfill, are:
1. Conditional Nature: Conversion of SAFE to equity is contingent on uncertain future events, such as a liquidity event or funding round.
2. Collateral Contingency: The event triggering the conversion is collateral to the main investment contract.
3. Independent of Promisor’s Will: The triggering events are pre-defined and not subject to the will of any party.
4. Condition Precedent: Performance (conversion to equity) occurs only after the specified condition is fulfilled.
Provisions governing iSAFE notes [Companies Act,2013]
1) Section 42 – Section 42 outlines the process for private placement of securities, which aligns with the structure of iSAFE notes offered to a select group of accredited investors.
2) Section 55 – This section governs the issuance of preference shares and specifies that CCPS must be converted into equity shares within a stipulated time or upon a triggering event. Triggering events could be IPO, Merger, Acquisition or Dissolution.
3) Section 62 – This section deals with the further issue of shares, such as rights issues and employee stock options, and allows the company to issue shares to existing shareholders or third parties. Upon conversion of iSAFE notes into equity, this section is triggered. The pricing of shares during conversion must adhere to the terms of iSAFE notes.
iSAFE notes are gaining traction in India, though not widely utilized. 100XVC invested close to $2.3 million as part of its 10th cohort through iSAFE notes. It has invested Rs 1.25 Crores in startups such as Arthum, Bepure, Buckmint, Cutbox, Dailybee and Datavio.
For the accounting of iSAFE notes, there are no clear standards or guidelines prescribed by the Institute of Chartered Accountants of India (ICAI). iSAFE notes are listed as “Preference Share Capital” because legally they are issued as CCPS. In a balance sheet iSAFE notes are typically classified under “Shareholder’s Funds”.
The tax treatment of iSAFE notes is not very clear. Section 47 (xb) of the Income Tax Act, 1961 can be examined. This provision clearly states that the conversion of preference shares into equity shares is not a transfer and, hence, not taxable.
Advantages to startup and investors
1) Benefits to Startups:
a) iSAFE notes do not accrue interest since its not debt
b) iSAFE notes are less expensive since experts need not be hired for drafting complex Shareholder Agreements (SHA)
c) iSAFE notes are simple documents that consist of 5-6 pages eliminating the need for 50-page contracts
d) The transaction can conclude in a span of 2-3 days ensuring timely funding
2) Benefits to Investors:
a) iSAFE notes get preference over equity shareholders in case the startup fails
b) Investors close deals within 2-3 days
c) There is no dilution in the cap table until a liquidity event or the next priced round
Risks associated with iSAFE notes
The concept of iSAFE notes is fairly new to startups, investors and corporate regulators. There are certain risks associated with enforceability due to its hybrid nature, combining features of both equity and debt instruments. The Companies Act, 2013 and its associated rules do not explicitly prohibit the issuance of iSAFE notes. iSAFE notes started gaining traction in 2019 and there have been no such publicly document disputes or notices regarding iSAFE notes.
When disputes arise there is question about the nature of the iSAFE notes because it is not fully an equity instrument since iSAFE notes convert into equity shares only on the happening of certain events or from 3 years of the issue of the note whichever comes earlier. It is neither a debt instrument since it does not accrue interest and does not appear as “debt” in the startup’s cap table. The nature of iSAFE notes is one of the important challenges that have to be addressed to promote investor confidence.
iSAFEs are marketed as “standard” and “industry-accepted” templates. However, labeling iSAFEs as standard contracts could have catastrophic consequences for the startup and venture capital industry. iSAFE notes have to be customized according to the investment, sector, and risk appetite of the investor. The template of the iSAFE could potentially serve as a guideline, but the specific conditions of the contract have to be customized. This could lead to startups and investors overlooking the need for legal counsel. Disputes may arise,e prolonging the investment process.
Though iSAFE notes provide startups with flexible funding, they create valuation risks. In an iSAFE note, a valuation cap or discount, whichever is higher, is usually provided as an incentive to the Venture Capital fund to make the investment. A valuation cap could potentially act as an anti-dilution provision. This is because, in subsequent rounds, such as Series A, the investors may get more equity shares if the valuation is less than the valuation cap.
iSAFE notes also mitigate some of the risks that were present with the Y combinator SAFEs. The original SAFEs are based on a triggering event and if this triggering event does not happen then the SAFEs do not convert into equity. However, in iSAFE notes the likelihood of this happening is close to impossible since the shares issued are in the form of CCPS.
Global Perspective
The Securities and Exchange Commission (SEC) of the United States of America (USA) issued a notice titled “Be cautious of SAFEs in Crowdfunding,” listing the risks associated with SAFEs that we have discussed above. One of the major risks highlighted in the notice was the fact that if the triggering event does not occur, the investor does not get any equity. However, this risk is solved in the Indian context since they are issued in the form of CCPS. The notice suggests that instead of a SAFE a convertible note which is a SAFE like security in some aspects could be issued. This is because it offers retail investors protection associated with being a debt instrument. However, convertible notes accrue interest, which might not be beneficial for a startup that is in its early stage requiring investment in Research and Development (R&D), Intellectual Property (IP), Operations, and Team Building.
Conclusion
iSAFE notes are an innovative approach towards early-stage funding and are tailored towards India’s startup ecosystem. However, the untested nature of iSAFE notes and the lack of clear regulations continue to limit its use in India.
The challenges associated with iSAFE notes have to be addressed proactively. The Venture Capital Fund and startups should customize the terms of the agreement to reflect the needs of the transaction. The investor and startups should negotiate a fair valuation cap that would ensure the founder’s ownership is not diluted to an extreme level. Furthermore, ICAI should issue guidelines for the accounting of iSAFE notes.
While iSAFE notes are no panacea, they address crucial challenges in startup funding. Since iSAFE notes are relatively new in India, the abovementioned challenges should be addressed through engagement with relevant stakeholders. Clearer regulations will also help promote their adoption.
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