Fieldfisher introduces the ASAP as alternative equity financing instrument under Dutch law for the Safe | Fieldfisher
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Fieldfisher introduces the ASAP as alternative equity financing instrument under Dutch law for the Safe

Jan Schouten



In our article The Simple Agreement for Future Equity (Safe) as pre-seed investment instrument in the Netherlands we have described the use in the Netherlands of the American Simple Agreement for Future Equity (Safe), a model participation agreement developed by YCombinator.

Application of the Safe model raises the question of whether the instrument in the Netherlands qualifies as debt or equity based on the agreed terms. The directors of the start-up and the appointed auditor should conform to the answer to that question when preparing the financial statements.

If the Safe including all necessary adjustments required in order to work under Dutch law would continue to qualify as debt, an alternative equity financing instrument is needed which meets the objectives of both the investor and the start-up. Fieldfisher introduces the Agreement of Subscription against Advance Payment (ASAP).

1.       Classification of the Safe as equity or debt

1.1     At the latest when drawing up the annual accounts, the management of the start-up company that has issued a Safe will have to qualify the value of the Safe as equity or debt. After all, the annual accounts must, according to generally accepted accounting standards, be drawn up in such a way that a responsible opinion can be formed about the company's capital and solvency. The annual accounts must accurately show the size and composition of the capital at the end of the financial year.

1.2     The start-up has an interest in a positive solvency ratio and will therefore want to qualify the Safe as equity. The investor who, by virtue of a Safe agreed upon with the start-up, has a right to acquire a percentage of at least five per cent of the issued share capital, can also have an interest in qualifying the Safe as equity; after all, his Safe then qualifies as a substantial interest and the investor-company is entitled to the participation exemption.

1.3     Under US law, the qualification of the Safe as equity seems to serve mainly a tax purpose, namely the application of a full or partial participation exemption. To achieve this tax purpose, the Safe model contains in its article 5 (g) an explicit confirmation by the parties that at all times the Safe will be classified exclusively as equity for tax purposes.

However, the US Internal Revenue Service (IRS) is not bound by the agreement to qualify the Safe as equity mentioned in clause 5(g) of the Safe model. However, the investor would have a weaker argument if this provision were not mentioned in the Safe. In qualifying a particular Safe as equity or debt, the IRS takes into account all relevant facts , including (i) the existence of subordination or seniority of creditors, (ii) the debt-to-equity ratio of the start-up, (iii) the relationship between shareholders and holders of the Safe, (iv) the name given to the investment vehicle, and (v) the intentions of the parties.

1.4     Also under Dutch law, all relevant facts and circumstances are taken into account for the qualification of the Safe as equity or outside capital. The law does not have a definition of equity, but Article 2:373 (1) of the Dutch Civil Code describes which balance sheet positions comprise the equity. The guidelines of the Dutch Accounting Standards Board (RJ) prescribe that in principle the legal form of the instrument is decisive for the separate financial statements, and for the consolidated financial statements the economic reality of the contractual provisions (RJ 290.804). Case law indicates that for the fiscal qualification of a grant of money the civil qualification of the grant will be decisive. Under Dutch law, the following requirements are relevant for the qualification as equity:

          (i)       subordination of the investor/lender to all the company's creditors (Subordination Requirement);
          (ii)      recoverability by creditors of the amount provided by the investor/money lender (guarantee function of the money supply) (Guarantee Requirement);
          (iii)     the existence or otherwise of an enforceable obligation of the Company to transfer cash or other financial asset to the lender under circumstances that are potentially adverse to the Company (Redemption Requirement);
          (iv)     the existence of a contractual obligation to issue a fixed number of shares (Determination Requirement);
          (v)      the existence or absence of conditions on the payment of dividends (Dividend Requirement); and
          (vi)     the civil law form of the provision of money, and in the case of a loan, the extent of the lender's participation in the company under the terms of the loan (Participation Requirement).

1.5     Upon analysis of the Safe under Dutch law, I establish that under the conditions of the Safe model the Safe meets the subordination requirement, but does not (entirely) meet the Guarantee Requirement, the Repayment Requirement, the Determination Requirement, the Dividend Requirement and the Participation Requirement. This reinforces the view that based on the Safe model the Safe qualifies as debt and not as equity. I will explain this in more detail below.

1.5.1  Requirement of subordination to the Safe

          The investor's claim to obtain the investment amount of the start-up in a liquidity event, which the Safe model defines as a transfer of control or an IPO, or an insolvency event, which the Safe model defines as the cessation of business activities, a general transfer of the assets for the benefit of creditors or the dissolution of the company, is subordinated to all creditors.

1.5.2  Guarantee requirement of the Safe

          Since the start-up company repays the investor the amount of the investment even in the case of a liquidity event and not only in the case of an insolvency event, it cannot be said that the amount of the investment unconditionally belongs to the start-up's liable equity capital.

1.5.3  Refund requirement for the Safe

          The Safe commits the start-up to repayment of at least an amount equal to the investment amount, in the event of a Liquidity Event or an Insolvency Event. If one of these events occurs, the Safe will not convert into shares in the capital of the start-up and the investor will not become a shareholder of the start-up.

1.5.4  Requirement of certainty of the Safe

          The Safe gives the investor a right to acquire a variable number of shares, in the sense that that number of shares depends on the issue price agreed upon during a new investment round. Only after this issue price has been determined, is the number of shares to which the Safe gives the right fixed, after application of an agreed valuation cap or a discount on the issue price. Also in the event of a consideration in shares in the case of a transfer of control or an initial public offering, the number of shares into which the Safe converts is only fixed after that event. This leads to the conclusion that the number of shares to which the Safe investor is entitled is variable, so that classification as equity under RJ 290.802 would not be permitted.

1.5.5  Dividend requirement for the Safe

          The Safe provides the investor with a claim against the start-up for the immediate distribution of a pro rata dividend amount, if a profit distribution has been paid out to holders of ordinary shares. The investor thus also obtains a claim to receive a dividend amount in the event that an interim dividend has been paid out to shareholders. While shareholders, in the event that the start-up company realises less profit for the financial year, are obliged towards the start-up company to repay the excess amount of profit distributed, the holder of the Safe who received the profit distribution during the financial year does not have this obligation. On the basis of the Safe model I conclude that the dividend right granted to the holder of the Safe is therefore not dependent on the realised annual result, which strengthens the qualification as debt.

1.5.6  Requirement to participate in the Safe

          The Safe is intended to provide the investor with a right to acquire shares in the start-up in return for payment of the investment amount. In addition, the investor has a claim against the start-up to a pro rata amount of dividend (see above in paragraph 1.5.4). The conversion right is however only exercised in the event of a qualifying financing round (Equity Financing). Since the Safe model expressly elaborates cases in which the investor has the right to receive back at least the amount of the investment, namely the Liquidity Event and the Dissolution Event, it must be concluded that the Participation Requirement is not entirely fulfilled.

2.       ASAP: a Dutch law alternative for the Safe

2.1     The introduction of the ASAP: the equity financing instrument under Dutch law
          At the request of Graduate Entrepreneur Fund, Fieldfisher has designed a Dutch law alternative to the Safe, which unlike the Safe does qualify as equity, called the Agreement of Subscription against Advance Payment or the ASAP. Like the Safe, the ASAP meets a need among startups to bind interested investors to the terms of a participation in the startup as soon as possible and in a simple manner, and to receive the investment amount from them. Below, I will elaborate on the specific provisions included in the ASAP in deviation from the Safe.

2.1.1  Right to acquire shares against immediate payment of the issue price

          The ASAP entails granting an investor the right to acquire shares in the start-up's capital (or certificates thereof) against immediate payment of the issue price. This right to acquire shares is granted by the general meeting of the start-up under the suspensive condition that the ASAP is entered into by the investor and the start-up. The payment of the advance on the issue price is booked under the equity position, other reserves (see Art. 2:373 paragraph 1 sub f BW; RJ 240.210).

2.1.2  Dividend entitlement

          The ASAP gives the ASAP investor the right to demand payment of a profit distribution from the start-up, if the start-up has realised profits over a financial year, the general meeting of the company has decided to distribute realised profits to the shareholders and the company has paid out these profits. The ASAP investor is therefore not entitled to a profit distribution if the start-up has paid out an interim dividend to shareholders. This fulfils the Dividend requirement.

2.1.3  Issue of ASAP shares

          The ASAP may provide for the shares to be issued in execution of the ASAP if any of the following events occur:

  1. the unconditional closing of the first financing round after the date of the ASAP, whereby the start-up issues shares to parties other than employees or a STAK in connection with an employee participation (Financing Round); or
  2. the unconditional closing of the transfer of more than 50% of the shares in the start-up leading to a transfer of control or a listing of shares in the start-up (Exit); or
  3. The application for a moratorium or bankruptcy, or the dissolution of the start-up (Dissolution Event).

          Under the conditions of a ASAP, the ASAP shares will always have to be issued. Any remaining amount of the investment amount after issuance of the ASAP shares will be booked as share premium. The investor has no right towards the start-up to repay the investment amount, so the Repayment Requirement is met.

2.1.4  Procedure for issuing ASAP shares

          The start-up sends a notice of the expected share issue event to the ASAP investor a certain number of business days before the intended date of issue of the ASAP shares. The notice confirms (i) the number of ASAP Shares to be issued to the ASAP Investor and (ii) the date of issue, in the case of a Financing Round or an Exit (iii) the identity of the new investor, and (iv) the number of shares to be acquired by the new investor and the agreed issue price, and in the case of an Exit the purchase price per share.

          On the date of issue, the start-up will issue the ASAP shares to the ASAP investor by executing a notarial deed of issue. This deed of issue will be passed in the event of a Financing Round immediately preceding the issue of shares to the new investor, and in the event of an Exit immediately preceding the delivery of shares to the buyer. In the deed of issue, the ASAP shares are issued under the condition precedent of the execution of the deed of issue of shares to the new investor and of the deed of transfer of shares to the purchaser, respectively.

          Following the issue of the issue of the ASAP shares, the investment amount booked as other reserves at the time of payment is moved pro rata to the equity positions, issued capital and share premium (Art. 2:373 (1) a and b BW; RJ 240.210).

2.1.5  Protection of the interests of the ASAP investor

          The ASAP investor is protected by an irrevocable order to the start-up to issue the ASAP shares to him before or, at the latest, at the closing of the new financing round. As an extra security, the ASAP can stipulate that a discount is applied to the calculated issue price of a certain percentage for every three months that the start-up is in default with the issue of ASAP shares.

2.1.6  Transfer of rights under the ASAP

          The ASAP should provide that the rights under the ASAP are transferable or encumbered with a limited right only with the consent of each party. The applicable statutory blocking rules included in the articles of association of the start-up at any time, including any offering obligations as a result of statutory events, will apply mutatis mutandis to a transfer of the rights under the ASAP.

2.2     Qualification as equity

          The ASAP qualifies as equity if the ASAP fully meets the requirements for such qualification and its classification as equity is permitted under RJ 240 and RJ 290. Under RJ 240.207, the ASAP that is structured as described in Section 4.1 can be classified as equity. If the ASAP provides a right to a fixed number of ASAP shares, which is the case when the ASAP is based on a fixed valuation, classification as equity is also permitted under RJ 290 and the Determination Requirement is met. The ASAP meets the Dividend Requirement (see Section 4.1.2 above), contains no obligation to repay the investment amount (Repayment Requirement), and a Liquidity Event or an Insolvency Event (Dissolution Event) will also lead to the issuance of the ASAP shares, thus meeting the Subordination Requirement and the Participation Requirement. The ASAP explicitly considers the investment amount as a paid advance on the issue price that the investor pays to the start-up for the acquisition of the shares that are issued on the occasion of the new financing round or at a Dissolution Event. The investment amount, once received by the start-up, thus forms part of its guarantee capital, so that the Guarantee Requirement is met.

3.       Summary and conclusion

          In our earlier article, "The Simple Agreement for Future Equity (Safe) as pre-seed investment instrument in the Netherlands" we commented that applying the Safe as a usable financing instrument under Dutch law requires several necessary adjustments to the Safe model. Even with these adjustments, however, the Safe is qualified as a debt financing instrument, and recharacterization as equity will only be feasible if the Safe model is changed in such a way that the requirements for qualification as equity are met.

          The start-up that wants to shape a future participation of an investor in the pre-seed phase as an equity financing instrument will find a tested Dutch-law alternative to the Safe in the ASAP that is shaped as described in Chapter 2.

Fieldfisher gladly assists pre-seed investors and start-ups with documenting equity investments in the form of an ASAP.