A Simple Agreement for Future Equity (SAFE) is a popular instrument in the start-up world to raise venture capital. SAFEs are mainly used in the US and UK through standardized documents where the company receives an investment amount immediately and investors convert their investment to shares in a subsequent investment 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 loan notes – that are compatible with the Danish Companies Act.

Summing up – our recommendation

No Danish company law regulation operate with SAFE as an investment tool. A SAFE therefore does not have any validity under the Danish Companies Act, but should instead be categorized as a common civil law agreement. It therefore only binds the parties who have entered into a SAFE (and thus typically not the company’s shareholders). A SAFE thus presents some significant challenges that suggests Danish lawyers should rarely recommend the use of SAFEs. For investors, there is no guarantee that the investment will actually be converted into shares. For the company, this can have significant tax implications. In addition, the “investment amount” does not add to the company’s equity, but constitutes a debt obligation, unnecessarily affecting the company’s liabilities (and thereby making the company less attractive to potential creditors and other investors), and which an investor may possibly demand to be repaid.

As an alternative to SAFEs, the use of a warrant (subscription right) or a convertible loan note should be recommended instead.

Warrants should be used when:

• the company’s valuation can be determined in advance,
• an exercise price can be indicated for the shares (typically par value),
• the investor will inject additional funds through the acquisition of shares on exercise; and
• when agreement can be rached on the portion of the share capital that the investor can subscribe to, but where the investor does not have to be a shareholder at the time of the conclusion of the warrant.

Convertible loan note should be used when:

• investors pay the investment amount immediately, but the valuation of the company is determined during a subsequent actual investment round,
• a bridge financing is carried out, i.e. the terms of the investment are negotiated by a (lead) investor in a subsequent investment round,
• there is a desire to offer a discount (Discount Rate) on a future valuation as compensation for the early investment, possibly combined with a cap on the valuation (Cap); and
• the company can bear the debt obligation the loan note entails.

If you nevertheless choose to use a SAFE – for example because the investor is foreign and does not want to deal with investment tools that are subject to Danish law – it is recommended that not only the company, but also all shareholders accede to the SAFE. This ensures to a greater extent that the shareholders at a general meeting are obliged to approve the conversion of the SAFE into shares.

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 shares in a company at a later date, typically at a future investment round where the company’s valuation is also determined. It is a quick way to raise venture 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 takes place later.

A SAFE gives the investor the right to convert their SAFE investment into shares in the company under certain events, such as a future investment round (Equity Financing), a valuation event (like a stock exchange listing) or an exit event. In other words, the investor is guaranteed conversion into equity at a later date. However, Danish law does not provide the same guarantee with SAFEs, which is discussed in greater detail below,.

A SAFE is typically a standardized investment document, which contains few terms and rights, thereby eliminating negotiation and administration. In practice, a few fields in the standardized document are filled in, the document signed, and funds transferred. However, a SAFE contains some important terms to be aware of:

• Post-Money Valuation: If the parties can agree on a valuation, it can be inserted in the SAFE. This will ensure that investors are aware of their ownership stake in the company at the time of the subsequent issue of shares.
• Discount Rate: If the parties cannot agree on a valuation or choose to postpone it altogether, a discount rate can be agreed on the valuation determined at the subsequent investment round. This compensates the investor for the additional risk associated with the early investment. The discount rate is typically in the range of 15-30%.
• Valuation Cap: There may be cases where the parties find it necessary to agree on an upper cap on the valuation of the subsequent investment round. This is typically to protect the investor from excessive dilution and/or the subsequent investment round being carried out at such a late stage that the investor is not properly compensated for the risk associated with the early investment.
• Liquidation Preference: There is a risk that the company will go bankrupt or dissolve (Liquidity Event or Dissolution Event) between the SAFE investment and the subsequent investment round. During this period, the investor has no rights, including liquidation preference, which is often seen when investors subscribe for preference shares with preferential rights. Therefore, it is often seen that a liquidation preference is agreed upon in a SAFE, which is a civil law agreement about a liquidation hierarchy, where the investor is prioritized over other shareholders, typically the company’s existing shareholders, in the event of any proceeds of a bankruptcy.

Therefore, a SAFE is a practical method for early investors and startups to enter into quick and flexible investment agreements without significant costs. However, as mentioned, there are legal challenges associated with the use of SAFEs under Danish law and the Danish Companies Act.

Challenges of SAFE under Danish law

Danish law does not provide for SAFEs or instruments comparable on a 1:1 basis. The problem arises when, in connection with the payment of the investment amount, no consideration (equity shares or warrants) is made, so it could hardly be argued that the investment amount contributes to equity. Therefore, in the absence of alternative accounting methods, the investment amount will be categorized as a debt (claim) owed to a SAFE investor, who converts this debt into shares in the company during a subsequent investment round. However, this is a process that is incompatible with the procedures for debt conversion under the Danish Companies Act, unless the conversion is approved at a general meeting.

Therefore, there are legal risks and potential conflicts associated with using a SAFE anyway:

1. Civil law agreement: The conclusion of a SAFE is considered a civil law agreement between the parties and does not automatically provide corporate legal protection for investors under the Danish Company Act, unlike convertible loan notes and warrants, where investors are entitled the subsequent conversion or subscription of newly issued shares. This means that investors entering into a SAFE may face difficulties when enforcing their civil law claims that the company should issue the agreed-upon shares. As a SAFE is typically entered into with the company – and thus not the company’s shareholders – it does not bind the shareholders, who may refuse to accede the general meeting resolution where the new shares are issued.
2. Valuation requirements: The Danish Companies Act requires  a valuation of the company when shares are issued. This is because the minimum and maximum number of shares to be issued must be stated. The Danish Companies Act provides fixed procedures in this respect for (other) investment instruments such as warrants and convertible loan notes, which SAFEs do not comply with. SAFEs typically do not determine a valuation at the time of entering into the agreement but defer this to a future conversion event.
3. Pre-emptive rights: The Danish Companies Act provides for pre-emptive rights for existing shareholders to subscribe new shares in proportion to their ownership stake in capital increases. A SAFE may conflict with these pre-emptive rights as it gives SAFE investors the right to subscribe for shares at a later stage without taking the pre-emptive rights of existing shareholders into account.

4. Accounting and auditing requirements: A SAFE may create uncertainty about how the investment should be accounted for in the company’s financial statements. The investment amount is unlikely to have contributed to the company’s equity. Although the circumstances may argue for treating the investment amount as a debt obligation, there is no accounting practice in this regard.

5. Tax implications: According to Danish law, dividends and gains from the sale of shares are subject to taxation. As a SAFE is not an share (but should entitle the holder to shares), it may be unclear how the tax rules should be interpreted in connection with the conversion of a SAFE into shares and how possible gains and dividends should be taxed. This can create uncertainty and potential tax consequences for both investors and companies.

These challenges make it necessary for Danish companies and investors to consider alternative investment structures that comply with Danish law and the Danish Companies Act, such as convertible loan notes and warrants.

How to address these challenges and what alternative ways are there to structure an investment?

A SAFE is an efficient and non-expensive instrument that combines the “best of both worlds” for risk-averse investors who want to invest in start-ups. The company receives access to capital immediately and without necessarily engaging advisors, and investors can defer the negotiation of commercial and legal terms while still obtaining the necessary legal protection.

Convertible loan notes and warrants are two financial instruments that can be used as alternatives to SAFEs when investing in Danish start-ups. Both instruments are in accordance with the Danish Companies Act and offer similar advantages as SAFEs. Unlike SAFEs, which under Danish law merely constitute a civil law agreement, for which there are no statutory content requirements, the Danish Companies Act contains content requirements for both convertible loan notes and warrants. Therefore, it can be argued that there is less flexibility associated with convertible loan notes and warrants compared to SAFEs.

Convertible loan notes

A convertible loan note is an ordinary loan note with the addition that the loan amount can be converted into equity against the issue of shares in the company. A convertible loan note is a loan granted by an investor to a company, with the option to convert the loan into shares in the company at a later date, usually under certain conditions or events (e.g. a future investment round).

The advantages of using convertible loan notes as an investment instrument are as follows:

1. Legal recognition: Convertible loan notes are a recognized form of investment under Danish law and the Danish Companies Act, providing clarity and legal certainty for both investors and companies.
2. Fixed interest rate: Since convertible loan notes are loans, the company pays a fixed interest rate to investors until the loan is converted into shares. This gives the investors a certain return, even if the conversion into shares does not occur. It can also be agreed that the interest is added to the principal so that more shares can be converted later.
3. Flexibility: Convertible loan notes can be adapted to different investment strategies and risk profiles, as the terms of conversion and interest payments can be negotiated between the parties.
4. Valuation cap: It is possible to insert an upper limit on the valuation. A valuation cap is introduced in convertible loan notes to protect investors from potential excessive dilution when the loan notes are converted into shares. The valuation cap is a tool that can be used to mitigate risk for investors and make convertible loan notes more attractive as investment instruments, especially for early investors in start-ups where uncertainty about the future valuation of the company is high.

The disadvantages of using convertible loan notes as an investment instrument are as follows:

1. Debt obligation: Since convertible loan notes constitute loans, they impose a debt obligation on the company, which affects the company’s liabilities and thus increases the company’s insolvency risk and makes the company less attractive to other creditors.
2. Creditor: Since convertible loan notes constitute a claim, the lender is considered a creditor rather than an investor. It is only when the creditor chooses to convert the loan that they become an investor. It is at the creditor’s discretion to choose whether they want to have the debt repaid (possibly with accrued interest) or whether they want to “wait and see” and convert the debt into shares. In other words, the creditor can “go both ways” and the company does not know whether it is “bought or sold” until the creditor has decided whether to convert or not. This uncertainty is an advantage for the investor and a disadvantage for the company.
3. Complexity: Convertible loan notes can be more complex than SAFEs as they require more negotiations and administration because they contain more terms and rights.

Warrants

A warrant is a subscription right that gives investors the right, but not the obligation, to subscribe for shares in a company at a certain price (exercise price) within a certain period of time. Warrants are not only a tool granted to employees as part of their remuneration. Warrants can also be used for investments, where investors can subscribe to shares when the company completes an investment round or reaches certain milestones.

The advantages of using warrants as an investment instrument are as follows:

1. Legal recognition: Warrants are recognized in Danish law and in the Danish Companies Act, providing legal clarity and certainty for both investors and companies.
2. Potential gain: Warrants allow investors to benefit from the upside of the company’s value increases without necessarily having to subscribe to the shares.

3. Protection against dilution: As warrants give investors a right, but not an obligation, to subscribe for shares in the company, they can be used as a form of protection against dilution of the investment. Investors may choose to exercise their warrants to maintain their ownership stake via their pre-emptive rights if the company issues more shares in the future.

4. Attracting investors: Warrants can be an attractive investment instrument for investors as they often have limited downside risk. If the market price of the shares falls and never exceeds the exercise price within the warrant’s validity period, the investor only loses the amount they may have paid for the warrants (warrant premium) and not the full value of the shares they could have subscribed to. This limited loss may make warrants more attractive to investors seeking higher returns with limited risk. This can make it easier for start-ups to raise capital and finance their growth.

5. Less influence on corporate governance: As warrants do not give investors voting rights until they are converted into shares, companies can continue to make decisions without the immediate influence of warrant investors. This can give company management and founders more flexibility and control over the company’s strategy and operations.

The disadvantages of using warrants as an investment instrument are the following:

1. Time limit: Warrants usually have an expiry date, which means that the investor must exercise them within a certain period of time. If this does not happen, the warrants lose their value, and the investor misses the opportunity to subscribe the shares.
2. Exercise price: Warrants have a fixed exercise price that the investor has to pay to convert the warrants into shares. Therefore, a price for the shares must be fixed at the time of issuance of the warrants.
3. Complexity: Warrants can be complex instruments that require management and monitoring by both investors and the company. This can lead to increased costs and use of resources in the administration and management of warrants.

In summary, convertible loan notes and warrants can be more administratively burdensome than SAFEs and entail certain disadvantages. However, both instruments’ validity is regulated by Danish law, thus providing clarity to the investor and the company on the subsequent process. Unlike SAFEs, the Danish Companies Act contains clear content requirements for both instruments, and there is a fixed procedure for their adoption and the procedure in case of conversion.

Conclusion

Danish start-ups face legal challenges when it comes to SAFEs under Danish law and the Danish Companies Act. To address these challenges, alternative investment instruments, such as convertible loan notes and warrants, may be more expedient. These legally recognized instruments can offer investors attractive return opportunities while limiting downside risk. By making the right choice of investment instrument, it is possible for both startups and investors to navigate the complex legal landscape and establish a solid foundation for successful investments and future growth.

At Samar Law, we are dedicated to providing legal support to both investors and start-ups in the early investment stages. We take pride in staying updated on the latest developments in the start-up industry. If you have any questions or need advice, please feel free to contact attorney Payam Samarghandi by e-mail at payam@samarlaw.dk or by phone on +45 60 79 37 77.