Why there is no safety in SAFTs

Simple Agreements for Future Equity are the complicated darling of the early-stage capital raising community, including as they often do not require a financial services licence in Australia. SAFE’s younger sibling, Simple Agreements for Future Tokens, are a natural evolution – but they are even more complicated when it comes to the regulatory licensing position and users should approach structuring them with real caution. Read our article to unpack these family issues!

Introduction

A simple agreement for future equity (SAFE) is an agreement between an investor and a company where the company promises to give the investor a future equity stake in the company if it undertakes an initial public offering or certain other trigger events occur.

SAFEs arose out of Silicon Valley as a way for venture capital investors to quickly invest in start-ups without burdening the start-up with negotiations as to what an equity offering may entail. They are a popular, if commercially risky given the economics / control offered by the product, way of raising startup capital as they do not generally require an Australian Financial Services Licence (AFSL).

Understandably, the market has moved to modifying SAFEs in connection with the future issuance of other products, most notably cryptocurrency tokens.  These are called ‘Simple Agreements for Future Tokens’, or SAFTs. But the same rules which apply to SAFEs do not necessarily apply to SAFTs, so caution must be exercised in constructing these instruments such that they do not trigger AFSL obligations.

The basics - SAFE notes

While these agreements are short in nature and allow for easy capital raising, there are appreciable considerations under Chapters 6 and 7 of the Corporations Act 2001 (Cth) (Corporations Act) in building effective SAFE notes.

Equity instruments typically require substantial disclosure and/or licensing requirements (e.g., an AFSL). A SAFE does not as it is generally considered a derivative.  Under section 761D of the Corporations Act, a derivative means an arrangement in relation to which the following conditions are satisfied:

1. under the arrangement, a party to the arrangement must, or may be required to, provide at some ‘future time consideration’ of a particular kind to someone;
2. that future time is not less than 1 business day; and
3. the amount of the consideration, or the value of the arrangement, is ultimately determined, derived from or varies by reference to (wholly or in part) the ‘value of something else’.

The underlying reference asset for structured products is a commodity, currency or something else in existence.  Given the breadth of the definition, the ‘something else’ encapsulates rights under a contract i.e. for the provision future shares. There are multiple examples of this type of derivative transaction occurring in structured product markets. As one example, which connects in with the discussion on SAFTs below, a pharmaceutical royalty swap is a financial agreement where one party (typically a pharmaceutical company) agrees to exchange future royalty payments from a drug or a portfolio of drugs with another party for an immediate lump sum payment or a series of fixed payments. The upfront payments are often used to design and manufacture the drug itself.

A derivative is captured under the definition of a ‘financial product’ within the Corporations Act, but when a derivative relates to the issuances of securities issued by the company itself, then section 766C(4)(c) of the Corporations Act i.e. the ‘self-dealing’ exemption, operates to obviate the need for an AFSL.  

AFSL requirements aside, the commercial risks of SAFE notes include:

1. Uncertain valuation: SAFE notes postpone the valuation discussion until a future date. This can lead to uncertainty and potential disagreements between investors and founders/owners when it comes time to determine the valuation, especially if the startup's performance or market conditions have changed significantly.  Indications of future value, including agreed valuation caps for fundraising rounds, should not be confused with the actual valuation of the company.  As Justice Jackman explained in ASIC’s recent court action against Block Earner, the valuation cap of the company during a funding round is not the same as the actual value of the company, but is simply the agreed value at which an investor’s debt will be converted to equity if a relevant trigger event occurs (such as a further funding round):  “It is thus (at most) a prediction of the company’s future valuation to manage risk and reward for investors, rather than a present valuation of the company”.[1]
2. No interest or maturity date: Unlike convertible notes, SAFE notes do not accrue interest or have a maturity date. While this can be advantageous for startups that may struggle to repay a loan, it can also mean that investors' funds are tied up indefinitely without the trigger event being appropriately defined.
3. Lack of investor protections: SAFE notes typically do not include many of the investor protections found in traditional convertible notes, such as conversion discounts, valuation caps, or repayment provisions.
4. Dilution concerns: Since SAFE notes typically convert into equity at a future financing round, they can result in significant dilution for early investors, especially if subsequent rounds of funding are at higher valuations. This can be a concern for investors who want to maintain a certain ownership percentage in the company.
5. Administration: If multiple SAFE rounds are issued or if there are changes to the terms of the notes over time, this can lead to higher legal fees and administrative burden for both startups and investors; it makes for a messy cap table.
6. Tax implications: Depending on the jurisdiction and the specific terms of the SAFE agreement, there may be tax implications for both startups and investors. Our examination of SAFE notes here is confined to the regulatory treatment of these instruments – the accounting and tax treatments may be different. 

More complicated - SAFT notes

Similarly, a SAFT is simply an agreement between an investor and a company where the company promises to give the investor tokens issued by the company if a trigger event occurs.  One trigger event, might be an initial coin offering (ICO).

Unlike convertible notes, depending on its legal structure, SAFEs (as distinct from SAFTs) are generally not considered debt instruments, as there is no inherent interest payable by the company upon the advanced amount, and no maturity date or repayment obligation. With SAFEs, there is no guarantee that the company will convert the advanced amount into equity but rather it is contingent upon an external salient feature. There is an open question where the SAFT is used to fund the ‘working capital’ of the entity, as that brings into consideration debentures (see ABN AMRO Bank v Bathurst Regional Council[2]).

Comparing SAFEs and the newer SAFTs:

1. with a SAFE, to compensate the investor for accepting risk, investors are entitled to convert their capital contribution into equity at the time of the qualifying priced equity round at a lower price than new investors. This price is usually at a fixed discount to the issue price (e.g., 20%) or based on a valuation cap; however,
2. for SAFTs, instead of a future promise of the delivery of equities upon the trigger event occurring, a SAFT issuance merely promises the contingent delivery of some form of token. That token is usually not equity in the company entity.

The economic value of the SAFT contract i.e. between the issuer and purchaser, derives from another ‘thing’.  In this case, the value of the forthcoming token. That economic value doesn’t stay static across a time horizon, as the value the purchaser of the SAFT acquires depends on things like the market price of the token, when they invested, etc.

What rights or value are associated with that token are completely variable and subject to the structuring of the token. Put another way, unlike a SAFE, the tokens may be disconnected from equity in the issuing entity.  The tokens associated with SAFTs may be indicative of rights to other financial instruments, commodities, revenue sharing rights, or something else entirely.  

Without a connection to the equity in the issuing entity i.e. its share capital, the ‘self-dealing’ exemption does not apply and a SAFT is a derivative which may require an AFSL to issue.  Very careful focus on the terms & conditions, and subsequent marketing, needs to be done, lest the organisation face civil and criminal penalties for unlicensed conduct.

Mirage lifelines  

The law surrounding SAFTs is complex, and emerging – at the time of writing there is not judicial or regulatory treatment of SAFTs (though ASIC has privately considered SAFEs).

Some arguments which may obviate the need for an AFSL for SAFTs, and the challenges with them, are set out below.

Limited trading

1. Entering into limited counterparty derivatives may not require an AFSL, as s. 911A only requires a person who carries on a ‘financial services business’ to hold an AFSL.
2. Naturally, that will be a question on the facts of each individual situation, through the line here should be drawn conservatively.

Forward contracts… for grain?

3. 761D(3)(a)(iii) of the Corporations Act provides for some exemptions to what is considered a derivative. Essentially, it excludes from the definition of ‘derivative’ arrangements for the supply of tangible property where one of the parties is actually expected to deliver the relevant property, and where rights and obligations under such arrangements are not usually traded, or not traded in a recognisable market.
4. Forward contracts for purchase of grain are not ‘derivatives’ or ‘financial products’ for the purposes of the Corporations Act (Keynes v Rural Directions Pty Ltd (No 2)[3]). That case turned on the nature of the underlying asset i.e. grains.  The contest was partly on whether a production failure leading to the inability to complete a deliverable contract i.e. deliver the grains, meant that the seller could hedge or cap its losses by entering into contracts to buy, satisfying ss 761D(3)(a)(iii).
5. On appeal, in Keynes v Rural Directions Pty Ltd[4], the Full Court found that
   1. none of the forward contracts permitted the seller wholly to discharge its obligation to deliver grain in cash or by set-off (see [46]), which would automatically fail the exemptive ss. 761D(3)(a)(ii), making the product a derivative;
   2. mere contracts for the sale and purchase of the asset, absent a secondary market e.g. future market here, are not caught under 761D(3)(a).  There was no market for this type of contract, and therefore no usual market practice, which permitted a close out of the arrangement with ‘the same kind of arrangement’ under ss. 761D(3)(a)(iii) (see [57]).
6. Accordingly, provided:
   1. the SAFT confers ‘tangible property’; and
   2. the SAFT doesn’t allow for cash settlement or set-off; and
   3. there is no identifiable ‘market’ for the SAFT, where close out with like obligations can occur, the exemption should be available. 
   4. However, leaving aside the secondary markets for SAFTs and whether they allow cash settlement, ‘tangible property’ is not defined under the Corporations Act, but commonly refers to assets that  have a physical presence and can be touched and measured e.g. grain.  It is highly contestable whether tokens are ‘tangible property’ in this regard, let alone whether the other factors which defined Keynes would apply to a SAFT.

Practical recommendations

It is highly attractive to explore SAFEs and SAFTs for early-stage capital raising for projects – the cost of obtaining and protecting an AFSL are appreciable.

However, without careful legal analysis and structuring, those hoping to utilise SAFTs may find themselves in hot water with ASIC.