1. Introduction

SAFE, a popular form of early-stage financing in North America, is not well received in Germany. However, it does work if the right mechanism is used.

2. SAFE in the USA

In the United States, the Simple Agreement for Future Equity (SAFE) has established itself as an entrepreneur-friendly and simple mechanism for the early-stage financing of start-ups. The SAFE agreement grants the investor the right to receive shares in a future financing round. It was introduced to the market at the end of 2013 by the start-up accelerator Y Combinator as an alternative to convertible loans and has since established itself in the United States and Canada.

3. Start-up financing via convertibles

In Germany, SAFEs are still not very common for early-stage financing. The use of convertible loan agreements (convertibles) continues to predominate. The main difference between a SAFE and a convertible is that a convertible is essentially a loan with a current interest rate and maturity date that can be converted into equity. In most cases, investors choose to convert the convertible into equity for ratio purposes. For the conversion into company shares, the convertible can provide for an agreed price per company share based on a company valuation. Alternatively, the convertible can also include a discount on the valuation in a future financ-ing round. To protect investors from an excessively high valuation, convertibles regularly provide for a cap on the conversion price.

4. SAFE: Implementation via authorized capital

What explains the low use of SAFEs in the German market? One reason is that it is impossible to transfer the American SAFE concept one-to-one to German corporate law. However, arrangements exist that can get around that obstacle. One way to implement SAFEs in German law is to use authorized capital in combination with a participation agreement between the start-up, the shareholders and the investors. As part of the participation agreement, the investor provides the start-up with money and in return receives an entitlement to subscribe to new company shares, which are created when the authorized capital is allocated as part of a later financing round. The financing round in turn determines the valuation. SAFEs also regularly provide for discounts and caps. This SAFE structure has no loan component.

5. Challenges

In Germany, however, the capital increase for corporations (including GmbHs) must be registered with the commercial registrar. In the commercial registration application, company management must confirm that the capital contributions have been made and are finally at the free disposal of the management. However, the staggered separation of the capital injection under the participation agreement from the subscription of new shares can lead to challenges when the management provides the required assurance. The funds received in the first step under the participation agreement are likely to have already been used up by the later date. Therefore, in addition to the investment already made, the investor must also pay the amount of the nominal value of the new company shares as part of the future capital increase. Tax risks, particularly in connection with gift tax, may arise both at the time of the initial capital grant and at the later date of the capital increase. Although these risks are usually dealt with in connection with the granting of liquidation preferences in the waterfall under the participation agreement, this could pose a challenge as the investor is not and will not become a shareholder when the participation agreement is concluded and it may be questionable at a later date whether the earlier investment can be attributed from a tax perspective to the new company shares created from the authorized capital.

6. Implementation via preferred shares

Another possible structure for the implementation of SAFEs under German law is the issue of preference shares to the investor against payment of the nominal value of the shares plus an additional payment. Since in this scenario the investor be-comes a shareholder of the company from the outset, the additional payment can be made into the company’s free capital reserves. To avoid gift tax problems and to protect the investor’s economic position, the investor’s equity participation is taken into account as a liquidation preference in the participation agreement. By joining the shareholders’ agreement, the investor’s legal and economic position is preserved. The preference shares that the investor receives in the course of the capital increase will then be converted into ordinary shares in a subsequent financing round, with the valuation of such a financing round in turn determining the conversion price. The participation agreement will contain detailed provisions on the conversion. With this structure variant, the capital raising regulations are preserved. Gift tax issues do not arise. Here too, the SAFE does not contain a loan element.

7. False conclusions around cost savings

It would be wrong to think that SAFEs cause high upfront costs that are not incurred with convertibles. It is true that the SAFE requires the negotiation of the participation agreement and that this will also have to be notarized in the case of a GmbH. How-ever, it would be wrong to think that such costs would not also be incurred in the case of a convertible structured prudently from an investor’s point of view. In addition to recent case law on the obligation to notarize convertibles, this is also supported by the expediency of negotiating the subsequently valid participation documentation. An investor will attach importance to this being available when the convertible is concluded.

8. Summary

When implementing SAFEs in Germany, special features of corporate law must be taken into account. This can be challenging when using authorized capital, as the time of the investment and the time of the granting of shareholder status are different. These disadvantages can be avoided by using a structure with preferred shares. This complexity under German law could be the reason for the low use of SAFEs in Germany and the general dominance of convertibles. On the other hand, it is not recommended to invest in an instrument without securing the investor position through a participation agreement. However, if the investor and founder conclude a participation and shareholder agreement, the conclusion of a SAFE can indeed be an advantageous alternative to a convertible in early-stage financing, as the legal and economic position of the investor is stronger from the outset.