Entrepreneurs in India often grapple with the complexities of financial instruments like the SAFE (Simple Agreement for Future Equity) notes, which, although popular in the United States, face legal challenges in India. The primary concern is that a US-style SAFE is not recognized within Indian legal frameworks, potentially resulting in violations under the Foreign Exchange Management Act (FEMA) or the Companies Act, where it might be misconstrued as a ‘Deposit’. This could lead to founders encountering significant obstacles when seeking Series A funding if these instruments were issued without proper structuring.
This article delves into the discrepancies between SAFE notes and Indian law, revealing how the Indian financial market has developed two viable alternatives to meet the demand for deferred-valuation instruments.
The iSAFE Instrument
The iSAFE (India Simple Agreement for Future Equity) is typically structured as Compulsorily Convertible Preference Shares (CCPS), which convert into equity shares at a predetermined valuation upon a qualifying event, such as a priced financing round, a liquidity event, or after a specified period. Since CCPS is recognized under the Companies Act, iSAFE operates within legal boundaries. It’s important to note that iSAFE is essentially a label that may also take the form of Compulsorily Convertible Debentures (CCDs), provided conversion into equity shares is mandatory and redemption is not an option.
In scenarios where redemption is necessary, instruments such as Convertible Notes (CN), Optionally Convertible Preference Shares (OCPS), or Optionally Convertible Debentures (OCDs) are considered, although OCPS and OCDs are unavailable to foreign investors under the standard Foreign Direct Investment (FDI) route.
For iSAFE instruments, adjustments to the company’s authorized capital may be required, and investors typically do not receive voting rights equivalent to those of equity shareholders. These instruments do not demand a fixed pre-money or post-money valuation, aside from the valuation needed for CCPS issuance, making them attractive in early rounds where valuations are contested. Foreign investors must comply with FEMA regulations from the outset.
Convertible Notes
Convertible Notes (CNs) are acknowledged under the Companies Act and Non-Debt Instruments (NDI) Rules, with specific conditions:
- Only startups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) can issue CNs.
- The minimum investment is Rs. 25,00,000 per investor in a single tranche.
- They must be converted or repaid within 10 years of issuance.
Until conversion, CNs are recorded as debt in the company’s books and must adhere to FEMA reporting requirements.
Challenges in Structuring
While these instruments are beneficial when deferring valuation, the real challenge lies in creating an accurate cap table for the priced round. Founders, eager to close rounds at deferred valuations, often overlook the mechanics of cap agreements, which can lead to unexpected outcomes. If the priced round valuation exceeds the agreed cap, early investors benefit, potentially disadvantaging founders. Conversely, if the priced round is undervalued, founders gain at the investors’ expense. This complexity is compounded by anti-dilution protections that may adjust the lower cap based on full ratchet or weighted average mechanisms during a down round.
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Complications increase when multiple unconverted instruments with varying caps, discounts, and conversion terms are stacked across sequential pre-priced rounds. Each instrument’s terms may lead to unforeseen outcomes when conversion is triggered, impacting the cap table at conversion significantly.
For CNs, if a qualified event for conversion does not occur by the maturity date, investors may demand repayment unless pre-negotiated remedies exist. A commonly overlooked provision is the Most Favoured Nation clause, which allows subsequent instruments offered on better terms to update earlier holders’ terms, aligning them with new conditions.
Regulatory Compliance and Instrument Selection
Regulatory compliance, particularly with FEMA, is crucial at the conversion stage, as the conversion price cannot be lower than the Fair Market Value (FMV) at issuance. The angel tax position requires attention, especially if the startup is not DPIIT registered, as a conversion above FMV may be considered additional income under tax laws.
The choice of instrument involves different terms for resident and non-resident investors, impacting compliance with FEMA and the Companies Act. The conversion trigger, often underestimated, is vital, especially if not clearly defined or if overlooked bridge rounds cause confusion regarding conversion events.
Addressing these issues during term sheet negotiations can prevent complications during Series A due diligence. Proper structuring from the outset is critical to avoid unforeseen challenges.
About the Author: Madhavan Srivatsan is a Senior Partner at Emerald Law Offices.
Disclaimer: The opinions expressed in this article are those of the author and do not necessarily reflect the views of Bar & Bench.
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