SAFE (Simple Agreement for Future Equity) Agreements is used when a startup is offering a new type of securities as part of crowdfunding offering. In which a startup offers future equity shares to the investors based on the investment amount and triggering event. The shares will be converted into equity if and only the triggering event occurs. but is SAFE Agreement valid in India?
Few private firms in India call it as an iSAFE Agreement (India Simple Agreement for Equity). but there is no such agreement recognized by the Indian Law.
However, there is another concept called as Debenture. It is like SAFE agreements but some of the terms differ and it is recognized by the Indian law.
Instead of issuing a SAFE agreement to the investors the start-up issues convertible debentures (Convertible Securities).
“Conversion Securities” means the shares of the series of convertible preference shares or Equity Shares, in either case, issued and allotted by the Company to the Debenture Holders in an Equity Financing.
Let’s understand in detail how Debentures are better than SAFE Agreements.
What are the types of Debentures?
In India there are two types of debentures.
- Non-Convertible Debentures (NCD):
- Compulsory Convertible Debenture (CCD):
NCD falls under the debt category. They cannot be converted into equity. Non-Convertible Debentures have a fixed maturity period and an interest rate.
The interest can be paid along with the principal amount wither annually, quarterly, or monthly depending on the fixed tenure specifies. However, considering the Deposit Rules, there are grater restrictions for the Private and Public Companies to accept the NCD from Individual Investors.
CCDs are like SAFE agreements; they can be converted into equity shares. CCDs are kind of hybrid security hence indicate of both debt and equity. In this article we will mostly be talking about CCDs.
CCDs yield a lower interest rate compared to NCDs. There are two types of convertible debentures.
- Fully Convertible Debentures
- Partly Convertible Debentures
We will discuss about these two in our next posts.
To whom will the startup issue debentures?
Debentures are to be issued by the startup in favor of the investor. That is debenture holders.
What are the benefits to the startups receiving their first investment through debentures?
Early-stage startup require funds to develop their product, to sustain in the market or for any other reason. But at this very early revenue stage assigning a valuation is unfair.
Specially when the startup is not generating any revenue. Hence offering debentures to the investors makes sure that the startup receives funds now and the valuation is done after completion of the tenure mentioned in the Debenture agreement.
Why is debenture preferred over any other investment instrument in India?
Debentures are hybrid security; they are neither debt nor equity. And there is very minimum interest occurring.
If in case the startup fails, the money that has left after paying other liabilities, will be returned to debenture holders in preference to equity shareholders.
When do debentures convert to equity shares?
Debentures are automatically converted into equity shares either on occurrence of specific liquidity event or in the valuation round, mergers/acquisitions, dissolution, etc. or at the end of the tenure period mentioned in the debenture agreement whichever is earlier.
Do debenture holders liquidity preference over equity holders / founders / promoters?
Yes, debenture holders have liquidity preference (to the extent of their invested capital), over Founders / Equity shareholders.
Do first debenture holders have liquidity preference over subsequent debenture holders or investors?
The first debenture holders will have equal preference over subsequent debenture holders or investors.
How will the debentures be reflected in the startup’s financials and will the company’s authorized & paid-up capital go up by the amount of investment made under the debenture?
The investment will be reflected as a debt under the financials of the company. The authorized capital and the paid-up capital will go up only when the debentures are converting in to the equity shares.
If you are a start-up/company in India who is raising funds, and need any help with funding compliances and legal, feel free to reach out to us at firstname.lastname@example.org or check out our Funding Compliances Package.