A Simple Agreement for Future Equity (SAFE) is a popular instrument in the startup world for raising risk capital. SAFEs are commonly used in the USA and the UK through standardized documents, where a company receives an investment amount immediately, and investors convert their investment into a later funding round. However, there are some legal challenges associated with using SAFE investments for Danish companies. This article will discuss the incompatibility between SAFEs and the Danish Companies Act and introduce two alternative financial instruments—warrants and convertible notes—that are compliant with the Companies Act.
Published on May 15, 2023
1. SUMMARY – OUR RECOMMENDATION
The Danish Companies Act does not recognize a SAFE as an investment tool. A SAFE, therefore, does not have any corporate legal validity but is instead categorized as a regular civil contract. It binds only the parties who have entered into a SAFE (typically not the company’s shareholders). Consequently, SAFEs present some significant challenges, which make it uncommon for Danish lawyers to recommend their use. For investors, there is no guarantee that the investment will actually convert into shares. For the company, it can have significant tax implications. Furthermore, the “investment amount” does not contribute to the company’s equity but constitutes a debt liability, affecting the company’s liabilities unnecessarily (making the company less attractive to potential creditors and other investors), and an investor might demand repayment.
As an alternative to SAFEs, it is advisable to use a warrant or convertible note.
Warrants should be used when:
- The company’s valuation can be determined in advance.
- An exercise price for the shares can be set (typically at par value).
- The investor is willing to inject additional funds by acquiring shares upon exercise.
- Agreement can be reached on the portion of the company’s capital that the investor can subscribe to, without becoming a shareholder at the time of granting the warrant.
Convertible notes should be used when:
- Investors pay the investment amount immediately, but the valuation of the company is determined in a later actual investment round.
- Bridge financing is carried out, meaning the terms of the investment are negotiated by a (lead) investor in a later investment round.
- A discount (Discount Cap) on a future valuation is desired as compensation for the early investment, possibly combined with a valuation cap (Cap), and the company can bear the debt obligation that the note entails.
If you still choose to use a SAFE—for example, because the investor is foreign and does not want to deal with investment tools subject to Danish law—it is recommended that not only the company but also all shareholders endorse the SAFE. This ensures to a greater extent that shareholders at a general meeting are obliged to approve the conversion of the SAFE into shares.
2. WHAT IS A SAFE?
A Simple Agreement for Future Equity (SAFE) is an investment agreement invented in Silicon Valley that gives investors the right to subscribe to shares in a company at a later date, typically in a future investment round where the company’s valuation is also determined. It is a quick way to raise risk capital without having to negotiate legal transaction documents, which can often be a time-consuming (and expensive) process. The investment amount is paid immediately, but the subscription of shares occurs later.
Danish law does not recognize SAFEs or instruments that can be directly compared to SAFEs. The issue arises because no consideration (shares or warrants) is given at the time of the investment, making it unlikely that the investment amount is recognized as equity. Therefore, in the absence of alternatives, the investment amount is technically categorized as a debt (claim) from a SAFE investor, who converts this debt into shares in a later investment round. However, this process is incompatible with the procedures of the Companies Act for debt conversions unless the conversion is approved at a general meeting.
A SAFE allows an investor to convert their SAFE investment into shares in the company under specific conditions, such as a future investment round (Equity Financing) or an exit event, a valuation event (like an IPO), or an exit event. In Danish law, there is no equivalent guarantee for SAFEs.
SAFEs are characterized by being a straightforward and flexible method for raising capital quickly and with minimal legal costs for startups in their early financing stages. A SAFE is typically a standardized investment document containing few terms and rights, eliminating the need for negotiation and administration. However, SAFEs do contain significant terms to be aware of:
- Post-Money Valuation: If the parties agree on a valuation, it can be included in the SAFE, ensuring that the investor knows their ownership percentage in the company based on the most recent share issuance.
- Discount Rate: If parties can’t agree on a valuation or choose to postpone it, it’s advisable to agree on a discount rate to be applied to the valuation set in the most recent investment round. This compensates the investor for the risk of the early investment. The discount rate typically falls within the range of 15-30%.
- Valuation Cap: Sometimes, it’s necessary to set an upper limit on the valuation in the subsequent investment round. This is typically done to protect investors from excessive dilution or because the later investment round occurs much later, and the investor isn’t sufficiently compensated for the risk of their early investment.
- Liquidation Preference: There’s a risk that the company may go bankrupt or dissolve between the SAFE investment and the later investment round. In this period, investors have no rights, including a liquidation preference as often seen when investors subscribe to preferred shares with preference rights. Therefore, it’s common to include a liquidation preference in a SAFE, a civil agreement about a liquidation hierarchy where investors have priority over other shareholders, typically the company’s existing shareholders, in the event of bankruptcy.
A SAFE is thus a practical method for early-stage investors and startups to enter into fast and flexible investment agreements without significant costs. However, as mentioned, there are legal challenges associated with SAFEs under Danish law and the Companies Act.
3. CHALLENGES WITH SAFES UNDER DANISH LAW
As mentioned earlier, the Companies Act in Denmark does not recognize SAFEs or anything directly comparable. Therefore, there are legal risks and potential conflicts associated with using a SAFE in Denmark:
- Civil Contract: The creation of SAFEs is considered a civil contract between the parties and doesn’t automatically grant corporate legal protection to investors, unlike convertible notes and warrants, where investors are guaranteed subsequent conversion or subscription of new shares. This means that an investor entering into a SAFE may have difficulty enforcing their civil legal claim that the company must issue the agreed-upon shares. Since a SAFE is typically entered into with the company and not the company’s shareholders, it doesn’t bind the shareholders. They may refuse to approve the general meeting’s decision to issue new shares, leading to uncertainty about how Danish courts will handle such agreements in case of disputes.
- Valuation Requirements: The Companies Act requires a valuation to be determined when issuing new shares. This is because it specifies the minimum and maximum amounts of shares to be issued. The Companies Act outlines procedures for other investment instruments like warrants and convertible notes that SAFEs do not meet. SAFEs typically do not set a valuation at the time of the agreement but defer it to a future conversion event.
- Pre-Emption Rights: The Companies Act includes pre-emption rights for existing shareholders to subscribe to new shares based on their ownership percentage during capital increases. A SAFE may conflict with these pre-emption rights as it grants SAFE investors the right to subscribe to shares at a later date without considering the existing shareholders’ rights. This can lead to disputes if existing shareholders believe that they have been improperly excluded from the capital increase.
- Lack of Legal Authority: The Companies Act specifies the rights of the company’s shareholders, including rights to participate and vote at general meetings and to receive dividends. A SAFE investor typically does not have these rights. As a result, conflicts can arise concerning the rights and obligations of SAFE investors under Danish law.
- Taxation: Under Danish tax law, it can be challenging to categorize a SAFE investment as equity. It can be viewed as a debt and could lead to unnecessary complexity and potentially higher taxes.
In summary, SAFEs are not a recommended investment tool for Danish companies, given the legal challenges and incompatibility with the Companies Act. This creates uncertainty for both investors and companies, making it difficult to enforce the terms of a SAFE agreement. To address these issues, it is advisable to consider alternative investment instruments such as warrants or convertible notes.
4. ALTERNATIVE INVESTMENT INSTRUMENTS: WARRANTS AND CONVERTIBLE NOTES
Warrants and convertible notes are well-established and recognized financial instruments under Danish law. They have standardized documentation and legal structures that provide legal protection and clarity for both companies and investors. These instruments can be used as alternative methods for raising capital while avoiding the legal challenges associated with SAFEs.
Warrants:
A warrant is a financial instrument that provides an investor with the right, but not the obligation, to purchase a specific number of shares at a predetermined exercise price. Warrants have the following characteristics:
- Fixed Exercise Price: Warrants have a fixed exercise price, which is typically set at the par value of the shares. This exercise price provides clarity on the terms of the investment.
- Subscription of Shares: Investors are granted the right to subscribe to shares at the exercise price, which ensures that they will become shareholders upon exercising the warrants.
- Corporate Legal Status: Warrants are recognized as equity instruments under Danish law, providing legal authority and protection for both companies and investors.
- Pre-Emption Rights: Companies can allocate warrants to investors without conflicting with the pre-emption rights of existing shareholders since the issuance of warrants does not immediately result in the issuance of shares.
Warrants are an excellent option when the company’s valuation can be determined in advance, and investors are willing to invest capital immediately. This makes warrants a more straightforward and recognized alternative to SAFEs.
Convertible Notes:
A convertible note is a debt instrument that can be converted into equity under specific conditions, typically in a later investment round. Convertible notes have the following characteristics:
- Investment Amount: Investors provide funds to the company as a loan (debt) under a convertible note, which allows for immediate capital injection.
- Conversion at a Future Round: The conversion of the debt into equity occurs at a predetermined valuation in a later investment round, typically in a subsequent equity financing event.
- Discount Rate and Valuation Cap: Convertible notes can include a discount rate and valuation cap to compensate investors for the risk of their early investment.
- Legal Protection: Convertible notes are well-established and recognized under Danish law, providing legal clarity and protection for both companies and investors.
Convertible notes are a suitable option when the company’s valuation will be determined in a later investment round, or bridge financing is needed, and the terms of the investment will be negotiated by a lead investor in a subsequent round.
5. CONCLUSION
SAFEs are not a recommended investment tool for Danish companies due to the legal challenges and incompatibility with the Companies Act. The lack of corporate legal recognition and the potential conflicts with existing regulations make SAFEs a risky choice for both investors and companies.
To raise capital while avoiding these issues, it is advisable to consider alternative financial instruments such as warrants or convertible notes. These instruments provide legal clarity, recognized corporate status, and protections for all parties involved, making them more suitable for Danish businesses seeking to attract investors and raise capital. Carefully consider the specific needs of your company and investors when choosing between warrants and convertible notes, as they have distinct features and are best suited for different scenarios.
Always seek legal counsel and consult with experts to ensure that you choose the most appropriate and legally compliant financing method for your business. It is essential to structure your investments in a way that aligns with Danish corporate and tax regulations and provides legal protections for all parties involved.
