Summary:
- We believe that generic SAFE agreements have a level of Gharar (uncertainty) and ambiguity in terms of the treatment of the investment for Shariah compliance.
- A SAFE can be easily tweaked for Shariah compliance and should be tweaked to ensure Shariah compliance.
- The first major objection is ownership; a SAFE can potentially be developed to give sufficient ownership relationships and rights to satisfy ownership for Shariah purposes.
- The second objection of Gharar can easily be addressed by valuation caps, time-limit to conversions.
- The third major objection is priority which should be dealt with by ensuring SAFE investors do not receive any preference upon liquidation.
- We conclude that having bona fide equity agreements and ordinary shareholder agreements is best for Shariah compliance. However, if SAFEs facilitate access to capital more efficiently and effectively, and shareholder agreements are not feasible or practical, then SAFEs structured in a particular way as proposed below have the potential to align with Shariah principles.
HISTORY OF SAFE
The SAFE agreement is a relatively recent addition to the seed financing toolkit, popularised by the premier start-up accelerator Y Combinator. When originally introduced by Y Combinator in 2013, the goal of the SAFE was to simplify the process of investing in an early-stage start-up via a seed financing, in advance of the company undertaking a Series A venture financing. The seed round was often a bridge to future financing, and the SAFE was seen as a uniform, contractual vehicle to issue shares in that future financing, with a potential benefit to the investor for making their investment early.
DEFINING SAFE
A SAFE (simple agreement for future equity) is an agreement between an investor and a company that provides rights to the investor for registered and legally recognised future equity. It is arguably among the most common forms of financing for early-stage high risk/reward start-ups.
TYPES OF SAFEs
The post-money valuation cap is one of the more popular types of SAFEs, but there are also discount SAFEs (where the investor receives shares based on a discount instead of a valuation cap), valuation cap and discount SAFEs (where both the valuation cap and discount are considered), or Most Favoured Nation (MFN) SAFEs.
Instead of a valuation cap or discount, MFN SAFEs allow investors to adopt the terms of another investor from whom the start-up raises funds, if they find those terms favourable. This kind of SAFE comes into play when a start-up is especially young and difficult to value.
CORE FUNCTION OF SAFEs
The core function of a SAFE is to enable an advance investment in a company to bridge finances until a larger financing round can be completed, at which time the advance investment will convert into shares, with the investor benefiting either from a discount in purchase price or a capped value.
As a one-document security with minimal terms to negotiate (pretty much just the valuation cap and share price), the SAFE should streamline the funding process and reduce the time and expense involved in negotiations and attorney review.
Unlike a straight purchase of equity, shares are not valued at the time the SAFE is signed. Instead, investors and the company negotiate the mechanism by which future shares will be issued, and defer actual valuation. These conditions generally involve a valuation cap for the company and/or a discount to the share valuation at the moment of the trigger event. In this way, the SAFE investor shares in the upside of the company between the time the SAFE is signed (and funding provided) and the trigger event.
SHARIAH CONCERNS
- OWNERSHIP
A SAFE agreement legally gives the right to future equity. Legally speaking, a SAFE is not a debt either. There is a debate regarding the accounting treatment of SAFEs.
From a Shariah perspective, if SAFEs do not give any equity, what would be the status of the funds? The funds would become a Wadi’ah (custodial funds) if the start-up did not use the money. This is because the start-up has idhn (permission) to take possession (Qabd) of the funds. However, as the funds would be used, the funds would become a Qard from a Shariah perspective. Thereafter, receiving any benefits could well attract Riba.
Therefore, Milkiyyah (ownership) must be developed for Shariah purposes and Shariah compliance. A start-up must restructure the SAFE and implement the following additional safeguards to make a SAFE satisfy as many Huquq (rights) of Milkiyyah, effectively mirroring an equity investment from the outset in terms of outcomes and consequences, thereby creating a Musharakah for Shariah purposes. This can be done by the following steps:
a. Insertion of specific clause – The best method to develop an equity investment for Shariah purposes is to add an explicit clause stating that the SAFE investor will be treated for all intents and purposes at par with shareholders. Of course, management and voting rights are not necessary for the SAFE investors. The principles of Shirkah in Shariah allow that management and voting rights are concentrated in a few shareholders. The key issues which will manifest parity for all parties are dividend income, dissolution and liquidity events. However, start-ups rarely pay dividends at such an early stage of a company.
b. Side Letter – A simple side letter can be developed in accordance with one’s jurisdiction to state the explicit treatment of the SAFE investment as an equity. Seek legal advice on this.
c. Dissolution event – If the company goes bust before a Series A funding round, the SAFE investors should be treated as equity shareholders and not receive any preference as if they were creditors.
d. Liquidity event – If the company is acquired before a series A funding round, the SAFE investors should be treated like ordinary shareholders in terms of rights to net profits.
At the time of a SAFE investment, there is generally no dividend payment nor any sale of the equity. It is very unlikely. All investors as well as the founders are awaiting the next round of funding. Therefore, in this early phase of the start-up, the only material risk of Shariah non-compliance is at a dissolution event or liquidity event, where a SAFE investor can be treated as a creditor or have greater rights than bona fide equity holders. Therefore, it is this risk that needs to be addressed primarily.
- GHARAR
Gharar in SAFEs are in two areas:
- Time of conversion
- Valuation at conversion
There is an element of Gharar and uncertainty with SAFEs whereby the conversion to legal equity is unknown and contingent on trigger events. Likewise, there is uncertainty over the valuation at which the conversion will occur. This Gharar needs to be addressed to satisfy the ownership for Shariah purposes. To remedy this Gharar, a SAFE seeking to be Shariah compliant must include:
a. Compulsory conversion Time limit – A SAFE should state an absolute end date by which the conversion into equity is exercised. This is critical for Shariah compliance because a SAFE terminates when the investor is issued Series A shares or gets paid cash per any of the provisions in the agreement. This means a SAFE can potentially hang around for a long time.
b. Valuation Cap – This ensures that the SAFE will convert into a minimum percentage of the company. Valuation caps are a limit on the pre-money valuation used to determine the conversion price. By limiting the pre-money valuation, valuation caps ensure that safes will convert into a minimum percentage of the company, as calculated prior to the financing. For example, If someone invests $1 million through a safe with a $10 million valuation cap, the safe will never convert into a number of shares that represent less than 10% of the company prior to the preferred stock financing. If the company sold preferred stock at a $20 million pre-money valuation, the safe would convert into $2 million worth of shares.
The issue with Gharar and that which can lead to dispute is the investor receiving less than expected. By having a valuation cap, there is clarity on the minimum, and therefore there is agreement and consent on this amount. If the investor receives more, this will not be a form of Gharar, rather there will be implicit consent and a fortiori the investor will be pleased to receive the extra percentage.
- NO PRIORITY
The third Shariah concern in SAFEs are priority and preferred stocks. SAFEs typically provide that, upon a dissolution or winding-up of the company (which is not in connection with a sale of the company), the SAFE holders are entitled to receive the purchase price of their SAFEs before the equity holders receive any distribution of the company’s residual assets. A Shariah Compliant SAFE should avoid any preferential treatment to SAFE investors. This ensures that for Shariah purposes, the SAFE investors are ranked pari passu with equity shareholders.
CALL TO ACTION
Bona fide ordinary shareholder agreements which are structured as Shariah compliant and give the investors equity legally from the outset are the best for Shariah compliance. They ensure rights and obligations are cemented and there is clarity and transparency from the outset. All shareholders are then at equal footing, though the founders may choose to retain managerial and voting rights, which is not a problem.
If ordinary shareholder agreements are not practical or feasible, then to raise funds cheaply, quickly and efficiently, a SAFE can be structured on the above principles to potentially align with Shariah, though any SAFE should and must be reviewed by a Shariah scholar to ensure Shariah compliance.
