DealMakers AFRICA Q3 2022
Food for thought:
SAFES AND REGULATORY aspects
Njeri Wagacha and Rizichi Kashero-Ondego
When we consider the modern venture capital (VC) space, the first instrument that comes to mind is a simple agreement for future equity (SAFE). SAFEs were introduced in 2013, by the American start-up accelerator, Y Combinator, and are essentially a financing document based on US law. The premise is relatively easy and attractive: (i) they are simple (as they adopt a standard form); (ii) they have low transaction costs (as they are barely negotiated); and (iii) they contain founder-friendly terms (as they are used to promote start-ups in their seed financing rounds).
To add to this, they have been adaptable for local jurisdictions. In the UK, the SAFE is known as an advance subscription agreement (ASA), and the main difference is that rather than an investor agreeing on a conversion to equity, it is for a subscription to shares.
In Austria, SAFEs are required to be executed in the form of a notarial deed, as is required for any agreement on the transfer of shares of a limited liability company.
In Sweden, the notion that a SAFE can convert into equity without the involvement of the shareholders, i.e. pre-emption rights, only applies if the SAFE is structured as a convertible instrument – the concept of conversion to equity is one that has to be negotiated amongst the parties.
Aside from the nascent risk that the start-up fails and the investment is not realised, one has to understand that there are risks that may outweigh the benefits of using SAFEs or ASAs. Indeed, we need to be aware that the enforceability of the SAFE may soon become an issue to consider.
The nature of SAFEs is that promised equity and other rights are only available to an investor on the occurrence of a triggering event. The equity, depending on the structure of the agreement, could be pre-determined in the case of a post-money valuation. Further, other rights could also be granted, which include board seats, board observer seats, participation in future SAFEs rights, and information rights, to name a few. Some of these rights, such as board seat and board observer seat rights, may even be granted before the conversion of the SAFE to equity.
Using Kenya as an example, a merger is defined in the Competition Authority Act No. 12 of 2010 (Competition Act) as an “acquisition of shares, business or other assets, whether inside or outside Kenya, resulting in the change of control of a business, part of a business or an asset of a business in Kenya in any manner and includes a takeover” (our emphasis). Further, the Consolidated Guidelines on the Substantive Assessment of Mergers under the Competition Act provide that the competition authority of Kenya will analyse the relationship between the parties on a case by case basis. Some of the factors that they will take into consideration are the ability to appoint, or to veto the appointment of a majority of the directors, or to materially influence the policy of the company in a manner comparable to a person who, in ordinary commercial practice, can exercise an element of control. Based on the definition, we can surmise that in some instances, parties will have to obtain consent from the competition authority for the grant of certain rights to an investor.
However, the question that arises is, should competition clearance be obtained and, if so, when? At the point of entering the SAFE? Or at the point of conversion? Further, is there a risk if local competition authorities refuse to grant approval or, instead, require onerous conditions to be fulfilled before approvals are granted? The greater question then arises as to what happens to the funds that have already been deployed? It is advisable that mechanisms be placed in a SAFE if the rights or equity being promised to the investor change the control of the business (as applicable to the jurisdiction). One may make it a condition to obtain approval from the competition authority before the conversion takes place and, in an instance where approval is not obtained, mechanisms may be included to ensure the ability to unwind the transaction, or to require that the investment converts to debt.
Reassuringly, in most jurisdictions, including Kenya, financial thresholds apply when seeking competition clearance and, in the case of start-ups, these may not be met. However, as an investor, it is important to consider the particular jurisdiction involved, the stage in which you are making your investment, the target’s current cap-table, its turnover, and the number of other SAFEs that may have been issued, prior to making the decision to seek competition clearance.
OTHER REGULATORY APPROVALS
In addition to the competition approvals, one also has to consider whether, with respect to a business, the SAFE is in a regulated industry such as insurance, oil and gas and digital lending. Depending on the regulatory authority, a regulated business may be required to notify a regulator or obtain consent before a new shareholder acquires a certain threshold of equity. In this case, one should consider implementing a mechanism to notify or obtain consent from the regulator before the conversion is finalised.
Local content requirements in specific jurisdictions should also be considered. In Kenya, for example, the insurance industry restricts foreign ownership: at least one third of the shares in an insurance company must be owned by a local. It is, therefore, prudent to ensure before investing in a regulated business that the shareholders maintain local shareholding requirements throughout the seed fundraising process to conversion into equity.
Further, it may be an additional obligation for a director to be deemed fit and proper by the regulatory authority before they take on the position as a board member. This may be of specific concern, especially where the investor obtains a board seat before the conversion to equity. In this case, one must obtain the required consent from the regulator. In the alternative, it may be beneficial for the investor to obtain information rights, giving them the right to receive all information from the board, instead of acquiring a board seat. However, this may not give the element of control that most investors are looking to obtain.
Similar to Sweden and the UK, Kenya provides for mandatory pre-emption rights in its company law. Therefore, the aspect of automatic conversion to equity will need to be carefully considered, depending on the governing law of the SAFE. It may be a requirement for a waiver to be obtained from shareholders before the conversion to equity. One might, therefore, need to consider whether it is permissible under local law to obtain consent before entering the SAFE.
In conclusion, entering into a SAFE, while relatively simple on the face of it, requires much more long-term thinking to ensure that both founder and investor are protected. As practitioners, we need to constantly analyse SAFE documentation to ensure compliance with local laws, to guarantee that our clients effectively reap its benefits. Regulatory and practical aspects need to be considered when one is trying to conclude a SAFE quickly. If acting for an investor, we must advise them that as the SAFE develops, caution needs to be exercised to ensure that their investment is protected.
Wagacha is a Partner and Kashero-Ondego an Associate | CDH Kenya