Can the Safe model be used in the Netherlands and what adjustments are needed?
In recent years, Dutch start-ups have become more interested in using the American Simple Agreement for Future Equity (Safe) as a financing instrument. In this article we explain how the Safe works and for what purpose is the financing instrument is used. In particular, we will assess whether whether the Safe can be used as a financing instrument under Dutch law and what adjustments are required for this.
1. What is the Safe?
1.1 The Safe is a model participation agreement developed by YCombinator (see http://www.ycombinator.com/documents/), and concerns a financing agreement intended to be governed by the law of one of the states in the United States of America. The following models are available: (i) based on a post-money valuation cap and no discount, (ii) application of a discount and no application of a valuation cap and (iii) no application of a discount or a valuation cap, but of the Most Favoured Nation (MFN), i.e. a right to the application of more favourable terms and conditions of subsequently issued convertible securities. Meanwhile, model agreements based on a valuation cap without the application of a discount have been drafted subject to the laws of Canada, Cayman Islands and Singapore.
1.2 The model participation agreement is commonly used by start-ups prior to the first investment round to raise capital from early stage investors. The Safe has been developed to serve as a financing tool that qualifies as equity; it is seen as an alternative to early stage fundraising, which requires a valuation of the company, and to the usual convertible loan, which has the disadvantage of qualifying as debt in principle.
1.3 The model agreements made available by YCombinator create a right to acquire a certain number of preference shares in a company for a purchase price that is paid immediately as an advance on the shareholding. The Safe model based on a valuation cap without the application of a discount gives the investor, in summary, the following rights vis-à-vis the start-up:
- prior to the closing of an investment round, the right to acquire a number of preference shares equal to the highest number of either (i) the advance paid divided by the lowest issue price for preference shares, or (ii) the advance paid divided by the post-money valuation cap divided by the number of issued shares, convertible securities and options (Safe Price) (see Art. 1 (a) Safe model;
- as a result of a transfer of control or an initial public offering, the right to a pro rata share of the proceeds realised by the company up to the highest amount of either the advance paid (Cash-Out Amount) or the amount to be paid on the number of ordinary shares into which the Safe would convert (Conversion Amount), in cash or, if offered to the shareholders, in another form (see Art. 1 (b) Safe model);
- in the event of the company being wound up, dissolved or declared bankrupt, the investor is entitled to a maximum of the value of the advance paid, whereby the claim is subordinate to all creditors, has equal ranking with the holders of preference shares, but has priority over the holders of ordinary shares (see Art. 1 (c) Safe model);
- after the distribution of profits by the start-up to shareholders, the right to a profit distribution equal to the amount paid per ordinary share multiplied by the advance payment paid divided by the post-money valuation cap divided by the number of shares, convertible securities and options issued per a certain liquidity event (Liquidity Event) and excluding the unissued option pool (Liquidity Price) (Art. 5 (c) Safe model).
2. Application of the Safe as a Dutch law financing instrument
2.1 Attractiveness of the Safe as a pre-seed funding instrument for start-ups
Accelerators, start-ups and investors in the start-up ecosystem in the Netherlands have been interested for years in standard templates of financing documentation that are simple, balanced and effective. A money loan agreement is a relatively simple document, albeit that the conditions for the claimability of the principal, the term and the desired security require attention and elaboration. The addition of a mechanism by which the principal with interest due can be converted into shares requires a valuation of the company and requires additional provisions and documentation (a shareholder resolution and a draft deed of issue). Since the introduction of the Safe in 2013 on YCombinator's accelerator platform, start-ups in particular have favoured the Safe, as the templates are freely accessible, have a professional look due to the U.S. investment terminology used and are often applied by start-ups.
2.2 Necessary changes to the Safe
The application of Dutch law to the Safe as a financing instrument is certainly possible with some substantial adjustments. In our opinion, without these modifications the Safe does define the conditions under which the investor provides the agreed amount to the start-up, however the investor would not aquire an enforceable right to acquire shares and the conditions under which the shares are issued would not be defined under Dutch law. I will deal with some of the desired amendments to the Safe below.
2.2.1 Grant of a right to acquire shares
Because the Safe is intended to provide the investor with a right to acquire shares, a shareholders' resolution must have been adopted, prior to the Safe being entered into, to provide that right and to exclude the pre-emptive right accruing to shareholders. In its Safe User Guide, YCombinator refers users of the model to their local legal counsel to assess the effectiveness of the Safe under their jurisdiction The Safe must contain a provision confirming that resolution.
2.2.2 Investor's rights in connection with the granting of rights to acquire depository receipts for shares
If the Safe intends to grant the investor a right to acquire depositary receipts of shares, it will have to state whether these depositary receipts will carry meeting rights and which special conditions are described in the administration conditions that apply to the depositary receipts of shares; preferably, provisions will be included that elaborate on the following subjects (i) the exchangeability of depositary receipts, (ii) the transfer requirements for effectuating the transfer of depositary receipts, (iii) the transferability of shares held by a foundation trust office (STAK), and (iv) the binding of depositary receipt holders to drag-along obligations and entitlement to tag-along obligations.
2.2.3 Transfer of rights under the Safe
Art. 5 (d) Safe model of the Safe model provides that, regardless of the title under which the Safe is transferred, it is transferable only with the consent of each party. Excluded from the consent requirement for transfer are certain permitted transfers, including the transfer by universal title of the Safe as a result of death and a transfer of the Safe to another company controlled by the Safe investor. The closed nature of a B.V., however, would prevent persons who, when executing the Safe, would have been bound as shareholders by transfer restrictions of the applicable statutory restriction regime. For that reason, it is desirable that the Safe should declare the applicable statutory restriction regime, including any offer obligations as a result of events determined in the articles of association, to apply mutatis mutandis. If the reference to permitted transfers is maintained, it should exclude those transfers to which the blocking rules would apply mutatis mutandis. Whether this applies equally to depositary receipts for shares should depend on the administration conditions laid down by the STAK Board at the time.
If rights to acquire shares are transferred as referred to in article 5 (d) of the Safe model by the start-up to another company, a new shareholders' resolution must be taken to grant the right to acquire shares in the new company that acquires the rights and obligations under the Safe.
2.2.4 Issuance of shares to implement the Safe
In order to implement the Safe, a number of shares are issued to which the investor is entitled by virtue of the calculated issue price. These shares are not issued by means of an 'automatic conversion', but by virtue of the execution of a notarial deed of issuance of shares immediately preceding the closing of the financing round to which the Safe refers; in practice, these Safe shares will be issued by means of a separate notarial deed.
2.2.5 Protection of the Safe investor's interests
Because the issuance of the Safe shares as described above requires the cooperation of the start-up in the preparation of the closing of the new financing round, the interest of the Safe investor in a careful execution of the Safe will have to be protected. This can be achieved by the Safe investor in the Safe giving an irrevocable mandate to the start-up to issue the Safe shares or Safe depositary receipts to the Safe investor prior to or, at the latest, at the closing of the new financing round, by signing the notarial deed of issuance of shares or the deed of allotment of depositary receipts.
2.2.6 Limitation of dividend right of Safe investor
The Safe gives the Safe investor the right to demand payment of a dividend from the start-up, if the start-up has made any dividend payments to shareholders. This dividend right thus also leads to payment of a dividend, as soon as an interim dividend is paid out to shareholders. Although a payment by a start-up to its shareholders of an (interim) dividend would be unlikely, retaining this dividend right could lead to a risk for the start-up in such a case. If the start-up were to make a loss over the financial year after all, the amount paid out as interim dividend would have to be paid back by the shareholders; however, the Safe investor would in that case not have to repay the dividend amount to the start-up.
2.2.7 References to US legislation
References in the Safe to US legislation (in particular definitions of "Change of Control," "Direct Listing," "Initial Public Offering," and the qualification of a Safe investor) cause uncertainty and should be deleted. Special attention should be given to the process of notifications described in article 5 (b) of the Safe and the reference in article 5 (g) of the Safe to U.S. tax legislation for the agreed qualification of the Safe as equity. These provisions should be redrafted according to Dutch law.
3. Summary and conclusion
Increasingly, the Safe is being used by Dutch start-ups to attract pre-seed investments. Applying the Safe as a usable financing instrument under Dutch law, however, requires several necessary adjustments to the Safe model, which are explained in this article. With the modifications described in Chapter 2, the Safe model can be used as a Dutch law governed financing instrument.
Fieldfisher gladly assists pre-seed investors and start-ups with documenting Safe investments subject to Dutch law.
In the next article we will assess whether the Safe in the Netherlands qualifies as debt or equity based on the agreed terms. We will also inform you if an alternative equity financing instrument which meets the objectives of both the investor and the start-up is feasible.
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