iSAFE Notes in India – Funding, Investment & Taxation

Understanding iSAFE Notes: A Deep Dive

What Are iSAFE Notes in India?

India’s startup ecosystem has witnessed the emergence of various funding tools designed to address the challenges of early-stage fundraising. Among these, the India Simple Agreement for Future Equity (“iSAFE”) notes have gained traction as an innovative funding mechanism tailored specifically for the Indian market. iSAFE (India Simple Agreement for Future Equity) notes are an innovative funding instrument designed to address the challenges faced by early-stage startups in India, particularly in securing funding without having to immediately establish a company valuation.

iSAFE notes are agreements to purchase equity shares of a company at a future date. They allow investors to put money into startups in an ‘unpriced round’ where the startup is pre-revenue and cannot be easily valued in exchange for equity shares that will be issued later. Unlike traditional funding instruments, iSAFE notes defer valuation to a future date, typically when a priced round occurs.

Why are iSAFE Notes used?

• Unpriced Funding: iSAFE notes eliminate the need for a precise valuation of the startup, making them ideal for early-stage companies still in their ideation or prototype phase.
• Quick Funding: They streamline the fundraising process, enabling startups to secure capital faster compared to traditional funding routes.
  

By deferring valuation to a future date, iSAFE notes help startups avoid over or under-valuing their company early on, which could hinder future fundraising or result in investor dissatisfaction.

How Do iSAFE Notes Work in India?

iSAFE notes operate on a simple premise: investors inject capital into a startup without determining its valuation at the time of investment. Instead, the capital is convertible into equity in a future round of funding or upon a liquidity event.

Here’s how iSAFE notes work in practice:

1. Investment without a fixed price: Investors contribute capital to the startup without agreeing on the price per share. The terms of the iSAFE note include a trigger event that will determine the conversion of the capital into equity at a later stage.
2. Conversion of the investment: When a specified event occurs, such as the startup raising a priced funding round or achieving a liquidity event (e.g., merger or acquisition), the investment in iSAFE notes is automatically converted into equity shares.
3. Valuation at the next funding round: The conversion price is determined by the valuation of the company at the next funding round. Investors typically receive a discount on the share price to compensate for their early-stage risk.
   

When do iSAFE Notes Convert into Equity?

• Next Funding Round: The most common trigger for conversion is the next priced round of funding.
• Liquidity Events: If the startup is sold, merged, or undergoes another significant event, iSAFE notes may convert into equity before the next round of funding.
• Set Time Limit: iSAFE notes must be converted into equity within a specific period, typically 20 years, as per Indian regulations.
  

Key characteristics of iSAFE notes include:

• They are structured as Compulsorily Convertible Preference Shares (“CCPS”) in India.
• They automatically convert into equity shares upon specified liquidity events (next pricing round, dissolution, merger, acquisition) or at the end of a specific number of years from issuance (not more than 20 years), whichever is earlier.
• They do not accrue interest as they are not debt instruments but do have a nominal dividend percentage attached to them.

Key Features of iSAFE Notes in India

iSAFE notes have several unique characteristics that make them attractive to both investors and startups. These features differentiate iSAFE from other traditional funding mechanisms and offer a more flexible approach for early-stage fundraising.

1. No Interest but Nominal Dividend Percentage

Unlike debt instruments, iSAFE notes do not accrue interest. However, they often come with a nominal dividend attached, typically around 1-2%. This feature makes them an attractive option for investors who want equity exposure without the complexities of traditional equity funding or debt.

2. Deferred Valuation

One of the defining characteristics of iSAFE notes is the deferred valuation. This means that investors do not need to agree on the valuation of the company at the time of investment. Instead, the valuation is determined during the next funding round when the company is better positioned to assess its worth. This approach benefits startups by allowing them to focus on growth instead of negotiating valuation early on.

Key Benefits of Deferred Valuation:

• Flexibility for Startups: No need to fix a valuation, which could be challenging for pre-revenue startups.
• Better Terms for Investors: They are rewarded with a discount when the startup raises a priced round in the future.
  

3. Conversion Triggers

iSAFE notes convert into equity upon specific triggers that can be tied to future funding rounds or major business events. These events include:

• Next Funding Round: The most common trigger where iSAFE notes are converted into equity shares at a discounted price, based on the valuation in the next funding round.
• Liquidity Events: If the startup is acquired, merged, or undergoes a similar liquidity event, iSAFE notes convert into equity at a pre-agreed price or discount.
• Time-based Conversion: If no funding round or liquidity event occurs within a set timeframe (usually 20 years), the iSAFE notes will convert into equity automatically, subject to the terms agreed upon at issuance.

Legal Framework of iSAFE Notes in India

Governing Laws & Regulations for iSAFE Notes

The legal framework governing iSAFE Notes in India operates under the provisions of the Companies Act, 2013, with specific sections addressing the issuance, compliance, and conversion of financial instruments like Compulsorily Convertible Preference Shares (CCPS), which iSAFE notes are structured as.

In India, iSAFE Notes represent a convergence of modern funding mechanisms with existing laws on convertible instruments. The legal framework ensures that these funding tools are valid and structured within established compliance requirements, providing clarity for investors and startups alike.

Section 42: Private Placement Provisions for iSAFE Notes

Section 42 of the Companies Act, 2013 lays down the process for private placements, including the issuance of iSAFE Notes. It specifically allows companies to raise capital through private placements, subject to certain conditions. Here’s how iSAFE Notes fit into Section 42:

1. Private Placement Process: iSAFE Notes are offered to specific investors (e.g., venture capitalists, angel investors) in a private placement, without offering them to the general public. This private nature of iSAFE notes allows startups to raise funds quickly without extensive regulatory approvals that come with public offerings.
   
2. Compliance with Section 42: For a private placement of iSAFE Notes, companies must:
   • Ensure that the offer is made to a selected group of investors.
   • Follow the prescribed format for the private placement offer letter.
   • Obtain shareholder approval and board resolutions to issue the notes.
     
3. Filing Requirements: Companies must file a return with the Registrar of Companies (RoC) detailing the private placement offer and the amount raised.
   

Section 55: Issuance and Redemption of Preference Shares

Section 55 of the Companies Act, 2013 governs the issuance and redemption of preference shares in India. As iSAFE Notes are structured as Compulsorily Convertible Preference Shares (CCPS), this section plays a crucial role in determining how iSAFE Notes are issued and redeemed:

• Issuance of Preference Shares: iSAFE Notes are issued as preference shares, and their issuance must comply with the requirements laid out in Section 55, which covers the terms of issuing preference shares, including the issuance process, pricing, and conditions of redemption.
  
• Redemption of Preference Shares: While iSAFE Notes are typically structured for automatic conversion into equity, Section 55’s redemption provisions apply when preference shares are not converted but are instead redeemed within a specified time. For iSAFE Notes, the time frame is usually 20 years (as per Section 55) within which the notes must be converted into equity shares.
  

Section 62: Further Issue of Shares Upon Conversion

Section 62 of the Companies Act, 2013 deals with the process for the further issue of shares. This is particularly relevant when iSAFE Notes convert into equity, as this section provides the legal basis for such conversions:

1. Conversion of iSAFE Notes: Once iSAFE Notes are triggered for conversion (via the next funding round or liquidity event), they convert into equity shares. This issuance is governed under Section 62, which outlines the procedures for offering new shares to existing shareholders or specific investors.
2. Rights Issue and Private Placement: Section 62 also covers the possibility of a rights issue or private placement to facilitate the conversion of iSAFE Notes into equity. iSAFE notes, when converted, must comply with the conditions set by the company’s Articles of Association, and shareholders may need to approve the issue of new shares.
3. Preemptive Rights: Shareholders may or may not have preemptive rights on the new shares issued during the conversion of iSAFE Notes. In some cases, iSAFE investors receive shares with priority or a discount, while others may issue them under the broader rights offering.
   

Regulatory Adaptations for iSAFE Notes

Though there is no specific law solely governing iSAFE Notes in India, they are structured within the existing legal framework to ensure compliance with Indian regulations, primarily through the use of CCPS. These regulatory adaptations enable iSAFE Notes to be a legally sound option for startups while addressing the unique needs of early-stage fundraising.

How iSAFE Notes Fit into India’s Existing Legal Provisions

• CCPS Structure: As iSAFE Notes are structured as Compulsorily Convertible Preference Shares (CCPS), they comply with the relevant provisions for the issuance of preference shares, including the rules for conversion into equity.
• Conversion Timeline: The Companies Act mandates that preference shares (i.e., iSAFE Notes) must convert into equity shares within 20 years of issuance, ensuring that iSAFE Notes are not held indefinitely and giving both investors and startups clarity on their exit strategy.
• Private Placement Compliance: By using the private placement provisions under Section 42, iSAFE Notes avoid the complexities of public fundraising and allow startups to raise capital quickly and efficiently while adhering to the regulatory framework set forth in the Companies Act.
  

Summary Table: iSAFE Notes Legal Framework

Section	Provisions	Relevance to iSAFE Notes
Section 42	Private placement provisions, filing requirements	Governs the private placement of iSAFE Notes and filing with RoC.
Section 55	Issuance and redemption of preference shares	Governs the issuance of iSAFE Notes as CCPS and outlines redemption terms.
Section 62	Further issue of shares upon conversion	Governs the issuance of equity shares upon conversion of iSAFE Notes.

Issuing iSAFE Notes: Step-by-Step Process

How to Issue iSAFE Notes in India?

Issuing iSAFE Notes in India is a structured process governed by the provisions of the Companies Act, 2013. This process ensures that startups can raise capital from investors in a legally compliant manner, using iSAFE Notes as a funding instrument. Here’s a clear, step-by-step guide on how to issue iSAFE Notes:

Step 1: Corporate Authorizations (Board & Shareholder Approvals)

Before issuing iSAFE Notes, startups must ensure that they have the necessary corporate authorizations:

1. Board Approval: The company’s board of directors must approve the issuance of iSAFE Notes. A board resolution needs to be passed that outlines the terms of the iSAFE Notes, including the amount to be raised, the conversion mechanism, and any applicable conditions.
2. Shareholder Approval: Shareholder approval may also be required, depending on the company’s Articles of Association and the specific conditions under which the iSAFE Notes will be issued. This approval is often obtained through an ordinary resolution passed during a general meeting of shareholders.
   

Step 2: Issuance through Private Placement or Rights Issue

iSAFE Notes are primarily issued through two methods:

1. Private Placement: Most commonly, iSAFE Notes are issued under the private placement process, which is governed by Section 42 of the Companies Act, 2013. This method allows the company to raise funds by offering the notes to a select group of investors without a public offering. Startups need to follow the steps outlined in the private placement rules, including:
   • Preparing a private placement offer letter.
   • Filing the necessary documents with the Registrar of Companies (RoC).
     
2. Rights Issue: In some cases, iSAFE Notes may also be issued through a rights issue, where the company offers these notes to its existing shareholders, giving them the right to purchase the notes in proportion to their existing holdings.
   

Step 3: Allotment and Post-Allotment Compliance

After the iSAFE Notes are issued, the startup must complete the following steps to ensure compliance:

1. Allotment of iSAFE Notes: After investor funds are received, the company must allot the iSAFE Notes to the investors. This is typically done via a board resolution, which records the allotment of the notes, including the number of notes and the investors’ details.
2. Issuance of Allotment Letters: The company must issue allotment letters to investors confirming their investment in the iSAFE Notes. These letters should detail the terms and conditions of the investment, including conversion terms.
3. Post-Allotment Compliance: Following the allotment, the company must complete various compliance steps, such as:
   • Updating the share register to reflect the investors’ holdings.
   • Filing the return of allotment with the Registrar of Companies (RoC) within the prescribed time frame.
   • Maintaining proper accounting records for the raised funds.
     

Documentation & Compliance Requirements

Issuing iSAFE Notes in India requires specific documentation to ensure compliance with Indian regulations. Here’s an overview of the essential documentation and post-allotment compliance:

Documentation Required to Issue iSAFE Notes

1. Private Placement Offer Letter: This document outlines the terms of the iSAFE Notes offering and must be presented to the investors. It includes:
   • Details of the company and its financial position.
   • The terms and conditions of the iSAFE Notes, including the conversion triggers, price, and timeline.
   • Rights and obligations of the investors.
2. Board Resolution: A resolution passed by the board of directors approving the issuance of iSAFE Notes. This document outlines the amount to be raised, the terms of conversion, and other relevant details.
3. Shareholder Resolution (if applicable): A resolution passed by shareholders (if required by the company’s Articles of Association) authorizing the issue of iSAFE Notes.
4. Subscription Agreement: This agreement is entered into between the company and the investors, confirming the subscription for iSAFE Notes.
5. Return of Allotment (Form PAS-3): This form must be filed with the Registrar of Companies (RoC) within 30 days of allotment to notify the authorities of the issue of iSAFE Notes.
   

Post-Allotment Compliance Requirements

1. Updating Share Register: After the allotment of iSAFE Notes, the company must update its share register to reflect the new investors and their holdings.
2. Filing with Registrar of Companies (RoC): The company must file a Return of Allotment (Form PAS-3) with the Registrar of Companies (RoC) within 30 days of the allotment, notifying the authorities about the issuance of iSAFE Notes.
3. Ongoing Compliance: The company must ensure ongoing compliance with the Companies Act, 2013 by maintaining proper accounting records and adhering to corporate governance practices as required by law.
4. Investor Communication: After the iSAFE Notes are issued, the company must continue to communicate with investors, providing updates on the company’s progress and informing them about any events that trigger the conversion of the notes into equity.
   

When Are iSAFE Notes Typically Issued?

Ideal Use Cases for iSAFE Notes

iSAFE Notes offer a flexible and efficient fundraising mechanism, particularly for early-stage startups in India. Here are the most common scenarios in which iSAFE Notes are typically issued:

1. Pre-Revenue Startups: How iSAFE Notes Help Early-Stage Companies

Startups at the pre-revenue stage often face a significant challenge: determining the company’s valuation. Traditional funding methods, which require a clear valuation, may not be feasible during this phase. iSAFE Notes help solve this issue by deferring the valuation to a later stage, typically when the company raises its next round of funding.

Why iSAFE Notes Work for Pre-Revenue Startups:

• No Immediate Valuation Required: Founders don’t need to worry about setting a valuation early on.
• Investor Confidence: Investors can still enter early with the potential for a discount when the valuation is set during the next funding round.
• Future Equity Conversion: iSAFE Notes convert into equity once a valuation is determined, making it a flexible tool for both startups and investors.
  

2. Unpriced Funding Rounds: Why iSAFE Notes Are Preferred

Unpriced funding rounds refer to investment rounds where the valuation of the startup is not yet determined. iSAFE Notes are an ideal tool in these situations because they allow startups to raise funds without having to fix a price per share at the time of investment.

Benefits of iSAFE Notes in Unpriced Rounds:

• Deferred Valuation: The price per share is determined at a future date, typically in the next priced round.
• Faster Fundraising: Startups can raise money quickly without getting bogged down in valuation negotiations.
• Attractive to Early Investors: iSAFE Notes often come with a discount on future shares, making them an appealing option for investors.
  

3. Bridge Financing: How iSAFE Notes Serve as Bridge Financing Between Rounds

Bridge financing refers to temporary funding provided to startups between major funding rounds. iSAFE Notes are an excellent option for this purpose, as they offer a streamlined way for startups to secure the necessary capital while they work toward a larger, priced funding round.

Why iSAFE Notes Work for Bridge Financing:

• Quick and Efficient: iSAFE Notes provide an easy way to raise funds without the complexity of traditional financing options.
• Deferred Valuation: Startups can raise funds without immediately determining a company valuation.
• Convertible to Equity: Once the startup completes a larger funding round, the iSAFE Notes automatically convert to equity, giving investors access to future growth.
  

4. Quick Fundraising: The Streamlined Process for Fast, Early-Stage Funding

Startups often face urgent cash flow needs, and quick fundraising is essential during early stages. iSAFE Notes offer a simple and fast mechanism for securing capital without lengthy negotiations or extensive due diligence.

Benefits of iSAFE Notes for Quick Fundraising:

• Streamlined Process: iSAFE Notes require less documentation and fewer negotiations than traditional equity funding or convertible debt.
• Speed: Entrepreneurs can raise funds quickly without the need for complex valuation or equity discussions.
• Faster Deals: iSAFE Notes facilitate faster capital deployment, helping startups hit key milestones before the next funding round.
  

Why Startups Choose iSAFE Notes

Startups favor iSAFE Notes for several reasons, especially given the flexibility and speed they offer compared to traditional funding methods. Here are some of the top advantages of choosing iSAFE Notes:

1. Simplified Fundraising Process

iSAFE Notes simplify the fundraising process by eliminating the need for a detailed valuation at the outset. This makes them a great option for early-stage startups looking for quick capital without the complications of equity negotiation.

2. Speed and Efficiency

Startups can secure funds quickly with iSAFE Notes, as they avoid the lengthy processes involved in priced equity rounds. The streamlined documentation and fewer negotiation hurdles make iSAFE Notes an attractive option for urgent capital needs.

3. Deferred Valuation

The deferred valuation mechanism allows startups to avoid the complexities of determining an early-stage valuation, which can be particularly difficult for pre-revenue businesses. The valuation is set in a later funding round when the company is in a better position to determine its worth.

4. Flexibility for Future Funding Rounds

iSAFE Notes provide flexibility by allowing startups to raise funds now without locking in a valuation. They are especially beneficial for startups anticipating future funding rounds at a higher valuation.

Advantages of iSAFE Notes in India

For Startups

1. Easier Fundraising Without the Need for Immediate Valuation

Startups can avoid the challenges of early-stage valuation by using iSAFE Notes. Investors agree to a future equity conversion without the need for setting a price immediately.

2. Flexibility for Future Funding Rounds

iSAFE Notes allow startups to raise capital now and determine their valuation at a future funding round, providing flexibility in terms of timing and pricing.

3. Reduced Legal and Negotiation Complexities

The process of raising capital through iSAFE Notes is simpler than traditional equity or debt funding. There are fewer legal requirements and negotiations, making the fundraising process quicker and more efficient.

For Investors

1. Deferred Valuation Allows Early Investment at a Discount

Investors benefit from early-stage access to startups at a discounted price, as they can convert their investment into equity at a discount when the valuation is set.

2. Conversion Rights into Equity in the Future

Investors in iSAFE Notes have the right to convert their investment into equity once the company reaches a priced funding round or a liquidity event. This provides them with potential upside when the company grows.

iSAFE vs Other Funding Instruments

iSAFE Notes offer several advantages over traditional funding methods like equity financing or convertible debentures.

Feature	iSAFE Notes	Convertible Debentures	Equity Financing
Valuation	Deferred valuation until future round	Requires a valuation at issuance	Immediate valuation needed
Conversion	Converts into equity at a discount	Converts into equity at set terms	Direct equity issuance
Fundraising Speed	Fast, with minimal negotiation	Slower, requires detailed terms	Slower, detailed discussions
Investor Rights	Equity conversion at future round	Interest payments before conversion	Immediate ownership in company

Common Pitfalls and Considerations for iSAFE Notes

Challenges for Startups

While iSAFE Notes offer a simplified way for startups to raise capital, there are potential pitfalls that founders should be aware of:

1. Potential Difficulties with Conversion Triggers and Valuation at Future Rounds

One key challenge for startups is the uncertainty around the conversion trigger events. These triggers—such as the next funding round or liquidity event—may not always occur as expected. If the valuation in future rounds is lower than anticipated, it could lead to unintended dilution for the founders.

• Impact of Lower Valuation: If the company’s valuation decreases in the next round, the conversion of iSAFE Notes could result in more equity being given to investors than initially expected.
• Delayed or Missed Triggers: If a liquidity event or funding round doesn’t happen as expected, the conversion could be delayed, leading to uncertainty for both founders and investors.
  

2. Managing the Cap Table After Conversion

When iSAFE Notes convert into equity, it affects the cap table (capitalization table), which tracks ownership stakes in the company. Post-conversion, startups may need to adjust their equity structure to reflect the new investor ownership, which could lead to potential conflicts or challenges in raising future rounds.

• Equity Dilution: Founders may experience more dilution than expected if iSAFE Notes convert at a discount.
• Shareholder Confusion: The conversion can lead to confusion among existing shareholders if the cap table is not well-managed or communicated.
  

Challenges for Investors

While iSAFE Notes are attractive for investors due to their deferred valuation and equity conversion potential, there are challenges they should consider:

1. Risk if Startup Valuation Does Not Meet Expectations

Investors face risk if the startup’s valuation in future rounds doesn’t meet their expectations. Since iSAFE Notes convert into equity at a future round’s price, a lower-than-expected valuation could result in investors receiving less equity than anticipated, impacting their return on investment.

• Discount on Shares: While iSAFE investors are typically offered a discount, if the company’s future valuation doesn’t meet expectations, this discount might not be as valuable as anticipated.
  

2. Timing of the Liquidity Event

The timing of a liquidity event (such as an acquisition or IPO) is crucial for investors in iSAFE Notes. If the liquidity event takes longer than expected, investors may have to wait for a prolonged period before seeing any returns.

• Delayed Returns: If the startup’s exit is delayed, investors may not see a timely return on their investment, potentially impacting their financial strategy.