Convertible Loan Agreements (CLAs) and Simple Agreements for Future Equity (SAFEs) have become popular investment instruments in the venture capital industry across the US, UK, EU, and other regions in recent years. These alternative investment forms have gained popularity because traditional fundraising methods are more time-consuming, complex, and expensive, and require an immediate valuation of the company. Given their increasing use, this article will examine what these investment instruments are, their key differences, and the legal aspects of their implementation in Latvia. Although CLA and SAFE are not yet widely used in Latvia, their use is possible and can provide benefits for both investors and companies.
CLAs
A CLA is a special type of loan agreement which, unlike an ordinary loan agreement, provides that the loan will or may be converted into shares of the company's capital in the event of certain circumstances occurring instead of repayment of the loan. Conversion means that the lender, by waiving its claim to the repayment of the loan, makes an investment in the capital of the company in return for the shares in the company by way of a contribution in kind. Convertible loans have gained a lot of popularity in the venture capital industry, including in the private equity sector. Convertible loans have gained popularity in Latvia due to the fact that they have fewer formalities and are quicker and cheaper to conclude compared to equity investments, they provide a higher level of protection for the investor's investment, and they help to avoid premature valuation of the company.
The most common events in CLAs that will or may result in a loan being converted into shares of the company are:
- At the time of the next round of equity investment in the company – when the company raises new investment in the form of equity financing from existing or new investors.
- In the event of a change of control of the company – where the company plans to dispose of a majority of its shares, merge with another company or sell a significant part of its assets.
- After the contractual maturity date of the loan – when the loan matures and has not been repaid.
As in a conventional loan agreement, in a CLA the investor retains the right to receive repayment of the loan in the event that the conversion fails or the company defaults. In addition to the principal amount, the investor is entitled to interest on the use of the loan, loan origination or commission fees (if any), default interest and other penalties provided for in the relevant agreement.
SAFE
An investment instrument known as a SAFE (Simple Agreement on Future Equity) allows a start-up company to receive investment from an investor immediately in exchange for giving the investor the right to receive future equity, which most often happens when the company has raised the next round of equity investment in the company.
SAFE was created and first used in the US in 2013. It was developed by venture capital fund and incubator Y Combinator to offer a simple and flexible way for early-stage companies to raise finance while reducing the legal and administrative costs associated with traditional methods of raising capital.
The main advantages of the SAFE are:
- Standard form and simplicity – SAFE contracts are usually based on the SAFE uniform templates (available here) developed by Y Combinator and rarely undergo significant changes. Consequently, investors are aware of such contracts and, given that they are not substantially modified, this significantly reduces the time needed to discuss the terms of the contracts. This significantly speeds up the process of raising finance, as the parties do not need to negotiate and edit contracts in detail.
- Flexible enterprise value - SAFE avoids the need to determine the value of an enterprise at the time of investment. The equity price is calculated based on the value of the company in the next financing round, often including favourable terms such as a discount or a valuation cap, which compensates these investors for the risk of investing earlier than the equity financing round.
- Burden of commitment on the investment - SAFE is not a debt instrument, which means that the company does not accrue interest on the use of the funds as it would in the case of a loan. This advantage is particularly important for early-stage start-ups as it allows them to focus on the efficient use and development of funds without worrying about the amount of interest payments or repayment terms.
- Advantages for the investor - SAFE offers the investor the opportunity to get involved in the company more quickly by making an investment at an earlier stage, before the next round of investment. As a reward for the risk taken by investing earlier than others, the investor may be granted a discount on the purchase price of the shares to be determined in the next financing round. Based on the potential increased value of the company.
- Cost and efficiency advantage - the use of the SAFE has fewer legal formalities, administrative and legal costs. The preparation and conclusion of the agreement is faster and more efficient compared to traditional methods of raising capital or CLAs. This is a very important consideration for early-stage companies, which may have very limited resources and need to raise finance quickly to secure their business and its growth.
However, the following drawbacks of SAFE should be noted:
- Risk of dilution of the relative shareholding: If the SAFE agreement does not set a valuation cap or sets it too high, the investor's share of the company's capital may be less than the investor expected and wished to obtain with his investment in case the company's valuation has increased rapidly and to a large extent after the SAFE was concluded and the investment made.
- Limited liquidity of the investment: The assignment of investments to third parties is generally prohibited or restricted, making it more difficult for the investor to recover or sell the investment and reducing the liquidity of the investor's investment.
- Limited influence in the company: By investing through a SAFE, the investor essentially provides only financing to the company and does not acquire any formal rights to participate in the company's management, decision-making or influence its strategy.
Despite the weaknesses of the SAFE, given its main advantages and its popularity in the US, this investment instrument is being adjusted and increasingly used in various European countries, including Latvia.
Main differences and key considerations of the CLA and the SAFE
While CLAs and SAFEs may initially appear to be very similar in substance - in both cases, the investor is making an investment in return for the right to receive shares in the company in the future under certain circumstances - there are important legal differences between these two types of investment agreements which should be balanced against other considerations, and which are described in the table below.
| Considerations |
CLA |
SAFE |
| The substance of the agreement |
Loan agreement with the right to convert the loan into equity shares instead of loan repayment. |
Share purchase agreement where the investment (payment for the acquisition of shares) is made upfront, but with the right to acquire shares in the future. |
| The burden on the company of receiving investment commitments |
The interest on the loan accrues to the company, creating additional liabilities until the loan is converted or repaid. |
No accruing loan interest or other short-term liabilities until the acquisition of shares. |
| Investment protection |
Until the loan is converted, the investor will be considered as a creditor with a preferential claim on the company compared to the company's shareholders. |
Until the acquisition of the shares, the investor will be treated as a creditor, similar to a convertible loan agreement, with a senior claim on the company compared to the company's shareholders. |
| Common events conversion / acquisition |
When the next equity round of investment in the company takes place;
In the event of alienation of a majority/controlling interest (>50%) in the company;
In the event of the company's liquidation;
In the event of a disposal of all or substantially all of the company's assets or the exclusive licensing or alienation of all or substantially all of the company's intellectual property.
Upon maturity date of the loan.
|
NWhen the next equity round of investment in the company takes place;
In the event of alienation of a majority/controlling interest (>50%) in the company;
In the event of any liquidation, dissolution or winding-up of the company, whether voluntary or involuntary;
IPO (initial public offering).
|
| Tax aspects in Latvia |
The relevant corporate income tax [3] or personal income tax [4] rules apply as to regards loans. Following the conversion of the loan and the acquisition of the shares the relevant corporate income tax [3] or personal income tax [4] rules apply to the acquisition of the shares and the resulting payments, such as dividend payments and capital gains on the sale of the shares. |
As an investment with a SAFE is not considered a loan, the relevant tax rules on corporate income tax [3] or personal income tax [4] on the acquisition of shares and the resulting payments, such as dividend payments and income from the sale of shares, apply. |
| Forms of agreement |
The contractual forms of convertible loans can vary considerably, and their terms are often tailored to the needs of the specific investment, making them more complex and versatile instruments. |
SAFE uses standard templates [5] developed by Y Combinator, to which only minor and insignificant changes are usually made. Additional adaptations may be necessary to meet the requirements of a particular jurisdiction, but as far as possible stick to the format developed by Y Combinator. |
| Legal framework in Latvia |
CLAs and SAFEs are not directly regulated by Latvian law, but the principle of contractual autonomy allows the parties to enter into such agreements within the limits set by the applicable law. |
| Pre-investment due diligence |
Before entering into a CLA or a SAFE, it is essential to carry out a thorough due diligence of the company, paying particular attention to the shareholders' agreements and the rights and limitations set out therein. These provisions may have a significant impact on the rights of the investor after the acquisition of shares, for example in relation to voting rights, restrictions on the disposal of shares or participation in strategic decision-making. |
[1] Section 154. Procedures for the Valuation of Property Contributions
[2] Section 153. Property Contributions
[3] Enterprise Income Tax Law
[4] On Personal Income Tax
[5] Safe Financing Documents Templates
Summary
CLAs and SAFEs are very popular alternative investment instruments in the venture capital industry, offering flexibility and efficiency for both companies and investors and are slowly gaining popularity in Latvia. The use of CLAs and SAFEs offers start-ups the opportunity to raise finance more quickly and easily, avoiding premature valuation and complex legal procedures. When choosing between a CLA and a SAFE, it is important to carefully consider the legal, tax and strategic aspects in order to maximise the benefits of these instruments and facilitate the company's growth and return on investment.
Authors: Jēkabs Senkāns, Lawyer in SIA “Venture Faculty” and Rūdolfs Riekstiņš, Junior Lawyer in SIA “Venture Faculty”
The information in this article is general and not intended as legal advice. It is for information purposes only and does not reflect any particular situation or circumstances and should not be relied upon as a source of professional advice.
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