iSAFE Notes - Fund Raising for Growing Startups

Unlocking Startup Potential: Harnessing the Power of iSAFE Notes for Early-Stage Funding

Fundraising is a crucial exercise for startups because it provides the financial resources, credibility, expertise, and flexibility needed to grow and succeed in a competitive marketplace. In this note, Compliance Calendar simplifies a novel way of raising funds for early stage startups - through iSAFE notes.

Decoding the Startup Founder's Dilemma: Priced Round vs. Unpriced - Which Path Leads to Success

A startup founder's dilemma between a priced round and an unpriced round is a critical decision that shapes the financial trajectory of the company. Opting for a priced round involves setting a valuation for the startup and offering equity in exchange for investment. While this approach provides clarity to investors and founders, it often entails complex valuation negotiations and potentially diluting founder ownership.

On the other hand, choosing an unpriced round, where the price of the equity is not fixed, allows founders to postpone valuation discussions and focus on building the business. This can expedite fundraising and simplify the process, while also introducing some uncertainty around future equity dilution and valuation. Founders can navigate this dilemma strategically by using iSAFE notes.

What is iSAFE and why is it important for your early stage startup’s funding journey

Assigning a value to a company that is still in its ideation, prototype , pre-production stage or early revenue stage is a difficult and ambiguous exercise for the valuer. iSAFE notes iSAFE stands for India Simple Agreement For Future Equity. These are ideal for companies that have just started out and are in their early stage by benefitting founders and investors alike. SAFEs are an internationally recognised way to raise funds. While it was popular in global markets, the VC firm ‘100X.VC’ is credited with popularizing isafe as an investment tool for startups in India.

The following are the distinct advantages of isafe notes as a funding tool:

• Allows founders the luxury of time to improve valuation - It offers more time to build the company to boost financial metrics, product, customer base and cash flows. All of these factors ultimately lead to better valuations.

• Win-win for founders and investors - It’s an ideal situation for founders as well as investors. Founders can gain without diluting their ownership and building the company to a higher valuation. Investors can get richly rewarded when the valuation rounds are completed. Investors also benefit from the fact that their investment is frozen without any risk of dilution till the fixed price valuation round is completed.

• Lesser legal complexities - It’s also a faster and less technical process compared to complex shareholders agreements. It’s also a one-document process that helps startups save on costs.

Difference between Compulsory Convertible Preference Shares (CCPS) and iSAFE notes

In India, there is no specific law for convertibles like iSAFE. Thus take the form of a Compulsorily Convertible Preference Shares (CCPS) for the purpose of recording in financial statements, taxation and legal treatment, due to their similarities with CCPS. However, there are certain differences, enumerated as below:

• Valuations - The biggest difference between CCPS and iSafe notes lies in valuation. While the former is an important component of a CCPS agreement, isafe notes do not require prior valuations.

• Board seat - A CCPS term-sheet generally insists on giving investors a seat in the board. Whereas, isafe notes do not typically have this requirement.

• Consent rights - A CCPS may require detailed paragraphs discussing shareholders rights and reserved matters, while isafe notes are relatively simple and include fewer clauses.

• Voting rights - A CCPS holding investor often insists on possessing voting rights. There is no requirement of granting voting rights to isafe note holders.

• Exit rights - A CCPS provides details on exit rights to the investors. In this regard, an isafe note favors founders as exit rights to investors may typically not be included until equity valuation.

Types of iSAFE instruments

1. Fixed conversion at a future - This is the simplest form of isafe, whereby there is conversion of the investment made, at a fixed valuation arrived at in future.

2. Valuation cap, no Discount - In this form of isafe, investors get equity based on the valuation arrived at. In case the valuation is high, the shares allotted to investors will be lower. This scenario favors founders who would naturally want valuations to be higher. In contrast, for a lower valuation, the investors will get more equity.

3. Devising a Valuation Cap - The valuation cap is the maximum price at which the note owned by an investor will be converted into equity. This is an important aspect, as the investor contributes a certain sum when the valuation is not carried out by the startup. The valuation cap serves as a reference point for pricing shares in future.

4. Discount, no Valuation Cap - Here, a discount is agreed on between founders and investors. The valuation cap is flexible and unfixed. For instance, let’s say the investors decide to put in money at 20% discount in that valuation round. If the valuation arrived at in future is INR 10 crores post-money, the iSAFE investors equity will convert their equity at INR 8 crores (after a 20% discount).

5. Valuation Cap and Discount - This option incorporates both valuation cap and the discount in the agreement.

6. Most Favored Nation - This is a safe option for investors, as the Most Favored Nation clause iSAFE holders to choose to inherit more favorable terms that are offered to subsequent investors. This can help initial investors allay fears of being treated differently or at prejudice to investors of a later round. This option brings all investors at par.

Provisions from the Companies Act for issue & Conversion, wherever applicable in the context of issuing iSAFEs

While there are no particular rules for iSAFE notes in India, certain sections of the Companies Act are applicable. These are concurrent provisions that apply to the issue and conversion of Compulsorily Convertible Preference Shares.

• Section 55 stipulates conditions for issuance of preference shares. Preference shares, as the name suggests carry priority rights over equity shareholders in two respects - payment of dividend and repayment, in case of liquidation of the company. In addition, this section prescribes that preference shares can be issued for a maximum period of 20 years, hence the same legal understanding is imputed to the conversion period for investment received via iSAFE notes.

• Section 42 deals with provisions on private placement of shares. It further stipulates conditions for such private placement of shares and mentions that the company issuing shares through this mode are barred from making any public solicitation, public advertisements or utilizing any media, marketing or distribution channels or agents to inform the public about such shares.

• Provisions of Section 46 and 56(4) are applicable for the issuance and delivery of share certificates. It also states that share certificates must be issued to the investor within a period of two months from the date of allotment. In case of iSAFE note holders, this period would be reckoned from the date of actual conversion of the investment amount into shares.
  

In addition, rules contained under the Companies (Share Capital and Debentures) Rules, 2014 and Companies (Prospectus and Allotment of Securities) Rules, 2014 must also be adhered to, for compliance purposes.

Examples of Indian startups that have used this instrument for the purpose of funding and Valuation requirements

Based on publicly available information, 100X.VC has invested in companies every year since 2019 using iSAFE notes. In the financial year 2022-23, it invested INR 125 Cr (over $16.5 Mn) in 100 early-stage startups in exchange for 15% equity in future. Some successful startups and early stage companies that have received funding using iSAFE notes are - Arthum, Bepure, Buckmint, Cutbox, Dailybee, Datavio, Flabs, Hatchfast, HYRGPT, JoySpoon, MiClient, Offside, Sprentzo, THAP, and Wasteful Insights.

Distinction between iSAFEs and Convertible Notes

The most crucial difference between a convertible note and iSAFE note is the inherent nature of these tools. A convertible note essentially is classed as a debt, while an iSAFE note is a convertible security that is classed as a non-debt, preference share.

Unlike convertible notes, since an iSAFE note is not designed to be a debt instrument, it does not accrue interest. This helps early stage companies as they do not have to create provisions for routine interest payouts and conserve precious working capital.

While an iSAFE note is not equity either, for legal compliance purposes, iSAFE notes carry a low non-cumulative dividend of 0.0001%. Since the iSAFE note holders are treated at par with preference shareholders, if the startup fails, the residuary funds are paid to iSAFE note holders, in preference over the equity shareholders. This benefit may not be available to Convertible Note holders until the debt is converted to equity.

Implementation and legal recognition of iSAFEs in Indian law - are iSAFEs enforceable?

The concept of iSAFEs is fairly new to India and the Indian corporate regulators. This raises concerns on the enforceability aspect of these instruments. However, The Companies Act, 2013 and its associated rules do not explicitly prohibit the issuance of iSAFE notes. Since the iSAFE notes gained traction in India in 2019, no regulatory notice or legal disputes regarding the legal validity of iSAFE notes have been publicly reported.

Potential risks - In case of disputes, the nature of iSAFE becomes debatable, as it is neither fully an equity instrument, nor a debt instrument and nor is its nature of debt like a convertible note. The iSAFE issuing startup may also not disclose the amount received under the iSAFE as “debt”. Given that the Indian Accounting Standards are silent on the exact accounting treatment of iSAFEs, these are classed as under ‘preference shares’.

Treating iSAFEs as a Future Share Subscription Agreement - Experts say that a more advisable form of implementing iSAFEs could be treating them as a standardized form of Share Subscription Agreement. This can be modified to disclose the entire amount received as advance sale consideration. Moreover, the ‘closing date’ of this agreement can be contingent upon the terms and conditions of the conversion date/conversion event taking place. This agreement could also reduce risks of the investor in case a liquidation event happens before the conversion date.

Preparing for an iSafe (Simple Agreement for Future Equity) - Notes to keep in mind as a founder

Before embarking on an iSAFE agreement with your investors, here are Compliance Calendar’s tips to keep in mind as a startup founder:

• Clear Value Proposition and Market Opportunities: Clearly articulate what unique problems your startup aims to solve and how your solution is innovative and unique. You must also demonstrate the size and growth potential of the market you're targeting. Investors want to see that there's a significant opportunity for your startup to capture market share.

• Metrics of traction and financial projections: All investors would like to see evidence of traction, such as user growth, revenue, partnerships, or product development milestones achieved to date. Even if your startup is an early stage company, it is important to record financial traction data and include them in your pitch decks for receiving funding via iSAFEs.

• Expertise and experience of founding team: Investors invest in people as much as they invest in ideas, so make sure to showcase why your team is well-positioned to execute the problem that your startup aims to solve. Our experts at Compliance Calendar can also advise on the right pitch for securing an investment through iSAFE notes.

• Exit Strategy: Outlining potential exit opportunities for investors, such as acquisition or IPO or mergers may make investors more confident of realizing a return on their investment. A potential risk with an iSAFE instrument for an investor could be figuring the conversion date. A date too far out into the future may not leave enough chunk of equity for the iSAFE note investors upon conversion.

• Terms of the iSafe: Clearly explaining the terms of the iSafe agreement, including the valuation cap, discount rate, and any other relevant terms can go a long way in making sure investors understand how the iSafe note works and what they can expect in terms of equity ownership.

Compliance Requirements for iSAFE notes

In a typical isafe arrangement, the investor and the startup agree on the investment amount, mutually sign an iSAFE agreement and the investor sends the startup the investment amount post completion of applicable legal and secretarial formalities.

• Authorizing the company to issue isafe notes - A proper Board Resolution must be passed for convening an EGM to issue isafe notes. Necessary resolutions, if required, to increase the authorized capital are required. Form MGT-14 should be filed with ROC within 30 days. The company should also file Form SH-7 with the ROC within 30 days.

• Negotiating an appropriate isafe agreement - The founders and investors must carefully decide crucial issues involved in the isafe agreement. This includes discussions on valuation cap, discount percentage, anti-dilution rights, conversion, transfer and other rights.

• Private placement or Rights Issue - At this stage, isafe notes are issued by way of either private placement of shares or by way of a rights issue. Once the amount of investment is received, Form PAS-3 must be filed, by assuming the securities being issued by way of isafe notes to be in the nature of preference shares.

Founders and investors may also additionally mutually agree on the following:

• Liquidation priority with respect to other shareholders, creditors

• Events that can lead to termination of the agreement (such as financial irregularities, legal non-compliance etc)

• Conversion in case of mergers

• Information rights that require the founders to furnish crucial information about revenue, product and profits on a periodical basis

• Arbitration clause, that requires all disputes to be settled by way of arbitration. It also helps to specify the jurisdiction, language, seat and applicable rules of the arbitration.

Conversion of isafe notes into equity shares

iSAFE notes are automatically convertible into equity shares either on occurrence of specified liquidity events viz. next pricing / valuation round, dissolution, merger / acquisition etc., or at the end of 3 years from date of its issue, whichever is earlier.

Frequently Asked Questions

• Which corporate structures are allowed to raise funds through iSAFE notes?

As per the Companies Act, 2013 only businesses incorporated as a company are allowed to issue shares. Since iSAFE notes are considered to be a form of preference shares, it is a prerequisite that the start-up should be incorporated as a company under the Companies Act, 2013 to be eligible to raise funds through a iSAFE note.

• In case of liquidation of the company, do the isafe holders enjoy any preference over founders?

Yes, iSAFE note holders have liquidity preference (to the extent of their invested capital), over Founders / Equity shareholders.

• Can a startup issue iSAFE notes to subsequent investors?

Yes, startups are legally allowed to issue as many iSAFE notes as necessary. Even when the business has gained significant revenue, a fair valuation can be arrived at in later rounds, and isafe notes can help both founders and investors.

Successfully raising funds from investors can serve as validation of a startup's business model, market opportunity, and team. Compliance Calendar’s experts can help your business target investors who have a track record of investing in startups similar to yours and who understand your industry while also seamlessly executing end-to-end legal requirements. Connect with our funding experts today who can lead your startup to rich investment opportunities and support from our wide investor network.