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Investment through iSAFE Notes

For start-ups with little or no revenue and an uncertain future, assigning a valuation sounds vague. Business valuation of any kind is never cut and dry. Early-stage bootstrapped companies (Start-ups) are generally either at Idea, MVP (Minimum Viable Product) or Very Early Revenue stage and hence it’s unfair to assign a valuation so early in the lifecycle.

Thus, to deal with the issue of valuation, iSAFE notes were launched in India in 2019 to do away with the need to state pre-money or post-money valuation, as the equity in favour of iSAFE noteholders is issued much later viz. at an equity pricing round, once the start-up has achieved some stable and sustainable revenues. Didn’t quite understand the concept clearly? Well, let us explain what iSAFE notes are in detail and then you can go around helping your peers understand this fairly new concept too.

“iSAFE” stands for India Simple Agreement for Future Equity. An investor makes cash investment in return for a convertible instrument. An iSAFE note is not a debt instrument, a founder-friendly convertible security note, that is beneficial for both startups and investors. To comply with applicable Indian law, iSAFE note takes the legal form of compulsorily convertible preference shares (CCPS) which is convertible on the occurrence of specified events.

How will an Investment in iSAFE happen?

The investor and the startup agree on the investment amount, mutually sign an iSAFE agreement (issued by the start-up in favour of the investors) and the investor sends the startup the investment amount post completion of applicable legal and secretarial formalities. An outstanding iSAFE note would be referenced on the company’s cap table like any other convertible security.

Why iSAFE notes should be preferred investment instruments in India?

An iSAFE is neither debt nor equity, and there is no interest accruing, (though for legal compliance purposes, iSAFE note carries a non-cumulative dividend @ 0.0001%). If the startup fails, whatever money they have left after discharging other liabilities, will be returned to investors/iSAFE noteholders in preference over the equity shareholders until iSAFE noteholders receive their investment amount. Such liability is on the company, not on the founder individually. A convertible note is debt, while an iSAFE note is a convertible security that is not debt.

When do iSAFE notes convert to equity shares?

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

What are the benefits of iSAFE notes over regular shareholder agreements?

The reasons to use the iSAFE notes for early-stage fundraising is that founders can close a deal with an investor as soon as both parties are ready to sign and the investor is ready to wire money, instead of trying to coordinate a single close with all investors simultaneously. Also, as a flexible, one-document security without numerous terms to negotiate, iSAFE notes help startups and investors save money in legal fees, and reduce the time spent negotiating the terms of the investment.

Do iSAFE noteholders have liquidity preference over Equity holders/Promoters/Founders?

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

However, as they say, 'Every cloud has a silver lining', so iSAFE notes may have some negative aspects as well. As mentioned earlier, iSAFE notes are an Indian version of SAFE notes used worldwide. The usage of SAFE notes begun in 2013 and there have been some backdrops as listed below:

  • Founders didn’t do the basic dilution math associated with what happens to their ownership stakes when these notes convert into equity, as long as they are receiving cheques to get their business going.

  • While VC deals remain marketed on a pre-money basis, sophisticated investors know that what matters most is the post-money. Unfortunately, what the CEO/founder forgets most often is that the notes have a multiplier effect in the post-money calculation; the more notes and the further the cap is from the new priced equity, the greater the variance between actual and nominal pre- and post-money valuations.

  • SAFE notes which went awry create undue negotiating tension between CEOs/founders and new investors, especially if this interaction occurs during the first priced equity round, because it is truly the first-time founders and other common stockholders see the dilution in real terms.

  • What often gets overlooked by founding teams when SAFE or convertible notes are issued is that a majority of the dilution has already occurred, by issuing notes. When the CEO sees his or her ownership fall from 78% to 35% in one fell swoop, they often assume and blame the new financing structure or the price.

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