Legal Structure of iSAFE Notes

iSAFE notes are classified as Compulsorily Convertible Preference Shares (CCPS) under the Companies Act, 2013. They are not treated as debt and do not accrue interest, making them more favorable for startups. For compliance purposes, a nominal non-cumulative dividend (typically at 0.0001%) may be included.

Compliance Requirements

• Incorporation: Startups must be incorporated as companies under the Companies Act, 2013 to issue iSAFE notes; partnerships or LLPs cannot issue these instruments.
• Legal Framework: Governed by Sections 42, 55, and 62 of the Companies Act, along with relevant rules.

Types of iSAFE Notes

There are five primary methods for issuing iSAFE notes in India:

1. Fixed Conversion: A predetermined number of shares at a fixed price on a set date.
2. Valuation Cap: Establishes a maximum valuation at which iSAFE notes convert into equity.
• Scenario 1: If the future valuation is below the cap, investors receive more shares.
• Scenario 2: If above, they receive shares based on the cap.
3. Discount: Converts at a discounted rate (usually 15-30%) to the next priced round valuation.
4. Valuation Cap with Discount: Combines both features for added flexibility.
5. Most Favored Note (MFN): Ensures iSAFE holders receive terms that are no less favorable than subsequent investors.

Differences

iSAFE Notes vs. Convertible Notes

Convertible Notes:

• Treated as debt and accrue interest.
• Can be secured or unsecured.

iSAFE Notes:

• Not classified as debt and do not incur interest.
• If a startup fails, iSAFE holders have priority over equity shareholders for any remaining funds.

iSAFE Notes vs. CCPS

While both iSAFE notes and CCPS are treated similarly under the Companies Act, CCPS holders typically have additional rights, such as:

• Exit Rights: CCPS holders often have a right to exit under a Shareholders Agreement (SHA).
• Board Representation: More common for CCPS holders to have board seats.

iSAFE Notes vs. Shareholders Agreement (SHA)

iSAFE notes aim to simplify the funding process by minimizing the need for a detailed SHA. Once a priced round occurs, the iSAFE is converted, and the terms are then governed by the SHA.

Benefits of iSAFE Notes

For Investors

• Delayed Dilution: Investors do not dilute their ownership until a priced round occurs.
• Simplified Process: The agreement is usually concise, reducing the time and costs associated with legal documentation.
• Priority in Liquidation: iSAFE holders have a preference over equity shareholders in case of company liquidation.

For Startups

• Non-Debt Instrument: iSAFE notes do not accrue interest, preserving the company’s debt-equity ratio.
• Simplified Documentation: The brief format of iSAFE notes reduces legal costs and complexities.

Requirements

Valuation Requirements

One of the key advantages of iSAFE notes is that they circumvent the immediate need for valuation, which is often difficult for early-stage startups. The valuation is deferred until a future funding round, simplifying the investment process.

Secretarial and Compliance Requirements

Key Steps in Issuing iSAFE Notes

1. Increase Authorized Share Capital: Pass a board resolution and file the necessary forms with the Registrar of Companies (ROC).
2. Enter iSAFE Agreement: Clearly outline terms such as valuation cap, discount, and investment amount.
3. Issue iSAFE Notes: Conduct the issuance through private placement or rights issue.
4. Allotment and Reporting: Convene meetings to allot iSAFE notes and file the requisite forms.

Accounting and Reporting Requirements

Though no specific accounting guidelines exist for iSAFE notes, they should be categorized under Preference Share Capital on the balance sheet, reflecting their status as CCPS.

Tax Implications

While iSAFE notes are a new concept in India with limited guidance on taxation, they are treated similarly to CCPS. The conversion from preference shares to equity is not considered a taxable event, but capital gains tax may apply upon the sale of converted shares.