The iSAFE option to start up funding: Legality and taxation

Mahak Agarwal | corplaw@vinodkothari.com

Navigating the world of fundraising for startups is no easy feat. This becomes all the more challenging for a pre-revenue start-up which cannot have a valuation. Amongst the several fundraising options available to a start-up, one of the budding and lesser-known sources happens to be iSAFE.

Origin

iSAFE, short for, India Simple Agreement for Future Equity, was first introduced in India by 100X.VC, an early-stage investment firm. This move was inspired by US’s ‘Simple Agreement for Future Equity (‘SAFE’)’, an alternative to convertible debt and the brainchild of an American start-up incubator. SAFE is a financing contract between a startup and an investor that grants the investor the right to acquire equity in the firm subject to specific activating events, such as a future equity fundraising.^[1]

So far as the success of SAFE in India is concerned, being neither debt (since they do not accrue interest), nor equity (since they do not carry any dividend or shareholders’ rights) or any other instrument, it could not carve its place in India and was cornered as a mere contingent contract with low reliability and security. On the contrary, iSAFE happened to be the game changer in the Indian context, being a significantly modified version of SAFE.

What is iSAFE?

iSAFE is an agreement to purchase the equity shares of the company at a future date. The investors put in their money in the unpriced round (i.e. where the startup is pre-revenue and it is not possible to attach a value to it of the startup subject to certain valuation conditions, in exchange for equity shares that will be issued at a future date.

Early stage funding for a start up is often a challenge especially in the unpriced round since no real valuation can be attached to it. The unique character of iSAFE notes finds its suitability here and does away with the valuation exercise, postponing it to a later date, i.e. when the next pricing round happens. Besides  this, iSAFE, a comprehensive 5-6 pager agreement, eliminates the requirement  of entering into extensive SHAs with investors which can often be a cumbersome process for early stage startups,  involving not just time and money but also the hassle of engaging legal counsel. Start-ups can now raise funds through a simple 6 pager agreement

When is conversion triggered?

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 the date of its issue, whichever is earlier.^[2]

Legality of iSAFE in India

There is no specific law governing convertibles like iSAFE in India. Hence, to ensure their legal validity, they have been so designed as to take the form of Compulsorily Convertible Preference Shares (CCPS) and are governed by Sections 42, 55, and 62 of the Companies Act of 2013 read with the Companies (Share Capital and Debentures) and Companies (Prospectus and Allotment of Securities) Rules, 2014. Further, since it is only companies that can issue shares, partnership firms and LLPs cannot issue iSAFE.

Having discussed the above, if one delves deeper into the legal structure of iSAFEs, the following questions may arise:

1. Could iSAFEs be designed as optionally convertible securities?

Our analysis: Optionally convertible securities provide an option to either redeem or convert the security into equity at a specified date. Note that iSAFEs are agreements for ‘future equity’. Upon the occurrence of specified events, these notes are automatically converted into equity. This is to say that they do not provide any redemption option. Accordingly, it would be impracticable to issue them as optionally convertible securities.

Another question that arises here is whether convertible notes are any different from iSAFEs. While the general characteristics of the two are very similar (being securities that are convertible into equity upon occurrence of specified events), however, convertible notes are in the nature of debt and give the holder the option to convert the debt into equity. This is in contrast to iSAFEs which do not give the holder an option of redemption and are required to be mandatorily converted into equity on the happening of the specified event.

2. Could iSAFEs be designed as non convertible securities?

Our analysis: Non convertible securities do not provide the option of conversion to equity. Going by the same logic as discussed above, iSAFEs being agreements for future equity cannot be issued in such form.

3. Could iSAFEs be designed as CCDs?

Our analysis: Upon analyzing, it appears that one of the reasons for designing iSAFEs as CCPS is to make them eligible^[3] for receiving FDI under the Foreign Exchange Management (Non-Debt Instruments) Rules (‘FEMA NDI Rules’), 2019.

Having said that, it must be noted that CCDs are also eligible securities under the FEMA NDI Rules^[4]. Accordingly, at the outset, there does not appear to be a strict rule preventing a company from issuing iSAFEs as CCDs with conversion features tied to a future equity round. In fact this would additionally provide debt fund raising options to start-ups. The only concern that seems to be involved here is the burden of interest obligation that start ups might find difficult to bear at the nascent stage. This could, however, be avoided by designing them as zero coupon CCDs.

From the above discussion, it can be concluded that iSAFE is in itself, no new invention but an instrument in the nature of CCPS with certain unique features suited to meet the needs of an early stage startup.

How is iSAFE different from CCPS?

iSAFE are typically just CCPS with a different nomenclature. The distinguishing feature of iSAFE is that no valuation is required at the time of investing and investors can only evaluate the business when it has reached a certain milestone, such as the priced fund raising round.

Valuation

At the early stage, assigning a value to a start-up might not just be difficult but also unfair to it. One of the primary features making iSAFEs attractive is that they eliminate the valuation requirements, especially at the pre-revenue stage, by postponing it to a future priced round of fundraising.

Although valuation is not required at the instance of investing, the valuation of the equity that will be acquired at the future stage is determined based on the following methods:

1. Fixed conversion method

The company issues a fixed number of equity shares at a fixed conversion price on a fixed conversion date.

2. Valuation Cap

Valuation cap refers to the maximum valuation at which the iSAFE notes will be converted to equity. From the start up pov, a higher valuation is desired whereas an investor would ordinarily try to pull down the valuation. Say, for instance, an investor makes an initial investment of Rs. 1 cr at a valuation cap of Rs. 10 cr.  Now, at the next pricing round, there could be two scenarios:

1. Lower valuation of priced round: Say, the priced round is valued at Rs. 5 cr. In this case, the iSAFE investors  will get 20% equity in the Company (1cr/5cr * 100).Here the iSAFE investors get a higher stake to compensate for lower valuation.
2. Higher valuation of priced round: Say, the priced round is valued at Rs. 15 cr. In this case, the iSAFE investors  will get 10% equity in the Company. (1cr/10cr *100)

3. Discount

Under this, the conversion happens at a discount to the next priced round. For instance, if an investor makes an initial investment of Rs. 1 cr at a valuation cap of Rs. 10 cr, the discount rate is 20%, and the valuation of the pierced round is Rs. 15cr then the valuation for the purpose of conversion would be at a discount of 20% on Rs. 15 cr i.e. at Rs. 12 cr. Therefore, the iSAFE investors  will get 8.33% equity in the Company. (1cr/12cr *100)

4. Valuation cap with discount

Here there is an element of discount along with valuation cap.

Continuing the above example, let’s say an investor makes an initial investment of Rs. 1 cr at a valuation cap of Rs. 10 cr and at an agreed discount rate of 20%  on the next priced round. Now, if the next prived round is at a valuation of Rs. 15 cr, the valuation that would be considered for the purpose of conversion would be Rs. 10 cr or Rs.12cr (15 cr –  10%), whichever is lower, i.e. 10 cr. Accordingly, the iSAFE investors will get 10% equity in the Company. (1cr/10cr *100)

5. Most favored note

Under this, the iSAFE investors are offered any favourable terms issued to the subsequent investors so as to keep them at par.

Accounting treatment

While there is no specific accounting treatment issued by the Institute of Chartered Accountants of India for iSAFEs, being legally in the form of CCPS, they are shown as capital under the head of preference shares. These will ultimately form part of ‘Shareholder Funds” in the Balance Sheet.

Taxation

From a taxation point of view, the taxability has to be examined in the following stages:

Stage	Issuer	Investor
At the time of issuance	Where the instrument is issued for a consideration which is higher than the FMV[5], the difference (the consideration as exceeds the FMV) should be taxable under the head income from other sources.[6]	Where instrument is issued for a consideration lower than the FMV, difference between the FMV and the cost of acquisition (consideration received by issuer) should be taxable as per S. 50CA of the IT Act
At the time of conversion of the instrument into equity	Pursuant to S. 47(xb) of the IT Act, any transfer by way of conversion of preference shares of a company into equity shares of that company is not regarded as a transfer and hence at the stage of conversion, no capital gain tax is attracted either on the issuer or the investor. However, the conversion ratio fixed at the time of issuance should ideally take into account the FMV of the equity shares to be issued in future.
At the time of transfer of the instrument	Not applicable	The shares are transferred for a consideration less than the FMV, taxable as per S. 50CA of the IT Act on difference between the fair market value of the shares and the cost of acquisition.   Further, in this case, if the instrument is acquired by the transferee for a consideration which is less than the aggregate FMV of the property by an amount exceeding Rs. 50,000, the same should be taxable as per S. 56(2)(x) of the IT Act on difference between the FMV[7] of the shares and the consideration.

Concluding remarks

In conclusion, iSAFEs offer startups a swift and streamlined method to secure funding without the burdens of intricate agreements. Their flexibility and efficiency have become invaluable assets for new businesses trying to stay ahead.

But, startup owners need to remember that using iSAFEs means they’ll gradually give up some ownership of their company. So, it’s important to think carefully before going ahead. In this scenario, engaging with experts, such as virtual CFOs, is widely regarded as best practice. These professionals can tailor iSAFE agreements to suit the specific needs of the startup, ensuring that critical elements like discount rates and valuation caps are meticulously calibrated.

By following this standard practice and seeking guidance from seasoned professionals, startups today are confidently navigating the realm of iSAFEs, positioning themselves for sustained success amidst the competitive startup landscape.

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^[1] https://cbcl.nliu.ac.in/capital-markets-and-securities-law/isafe-notes-a-safe-tool-of-investment-in-indian-start-up-paradigm/

^[2] https://www.100x.vc/isafe

^[3] The definition of ‘equity instruments’ under Rule 2(k) of the FEMA NDI Rules includes fully and mandatorily convertible preference shares which are fully paid.

^[4] The definition of ‘equity instruments’ under Rule 2(k) of the FEMA NDI Rules includes fully and mandatorily convertible debentures.

^[5] For the purpose of taxability, S. 56(2)(viib) of the IT Act should apply to iSAFEs and the valuation should be done as per Rule 11UA(2) as applicable to CCPS

^[6] A specific exemption has been carved out for consideration for issue of shares received by a venture capital undertaking from a venture capital company or a venture capital fund or a specified fund. In other words, venture capital undertakings would not be required to pay tax on excess of consideration over the fair market value of the securities. This means that they are free to determine the fair market value of their securities. Now,most venture capital undertakings are start ups and often not inclined towards opting for the conventional valuation methods of the section. Accordingly, it appears that these venture capital undertakings (issuing iSAFEs) can opt for valuation methods discussed in this article above.

^[7] The methods of valuation are provided under Rule 11UA(1).