For decades, the SAFE contract type in the US has facilitated the raising of capital for start-ups with high future potential. Meanwhile, under Hungarian law, the same can currently only be done in a cumbersome and circuitous way. However, a recent amendment proposal seeks to fill this gap.
What is SAFE?
A SAFE (Simple Agreement For Future Equities) is perhaps the most common type of contract in the US venture capital market for investments in start-up companies. It is the type of contract that has been used to finance companies such as Airbnb, Dropbox and Reddit. The idea behind the creation of SAFE was the contract type that would be fully accepted by the market, where essentially only the numbers would need to be entered by the parties and the other terms would not be negotiated because they would be uniformly known and accepted by both sides. This avoids multiple, expensive and lengthy contract negotiations and minimises consultancy costs - all at a stage where a realistic valuation of the target company cannot be made.
What exactly does a SAFE contract look like?
In a SAFE arrangement, at the time of signing, the investor provides direct funding to the start-up. As no data on the value and profitability of the company is available at this stage, the investor is merely financing an idea and its feasibility - bearing as much risk as possible.
Another essential element of the SAFE scheme is the automatic conversion into equity: in the event of a subsequent third party investment, the SAFE investor automatically receives a stake in the company at a discounted rate or a predetermined ceiling on the company value. The investor realises in this discounted firm value the countervalue of the risk he assumes by the initial financing.
If the investment is still not successful and the company becomes insolvent or is wound up, the SAFE investor will have priority rights upon the distribution of the assets. However, there is no guarantee that the full amount invested will be returned.
All these elements and rights are set out in the SAFE contract in relatively simple terms. In contrast to the hundreds of pages of documentation for subsequent joint equity investments, the SAFE model contract is only six pages long (and not printed in the smallest font).
Why doesn't SAFE work in Hungary?
As SAFE is an easy, quick and painless method of raising capital, the Hungarian venture capital market is in great need of its use. However, the current Hungarian legal system puts many obstacles in its way.
SAFE cannot currently be categorised into a single type of contract, it contains the characteristics of several contract types regulated by Civil Code. It includes the elements of a loan, the characteristics of a right a pre-emption, and the characteristics of a convertible bond. However, since SAFE does not correspond exactly to any of these, a lawyer must tread carefully among the legal options available, stretching them to the maximum and often using unconventional techniques. This, of course, prolongs the legal work, requires that all parties agree on the legal aspects of the scheme and that none of them feels that they are not fully benefiting from any of the legal safeguards inherent in the SAFE scheme. This uncertainty and overthinking takes away the greatest benefit of SAFE.
On the other hand, the interpretation of whether regular financing through SAFE is not a licensable activity is also vague. SAFE is an atypical loan, and commercial lending can only be carried out with a licence from the National Bank of Hungary (NBH). No angel investor is likely to want to go through a lengthy licensing procedure in order to lend money to a business he wishes to invest in.
Light at the end of the tunnel
In the current situation, it gives hope that a recent legislative proposal would designate capital advance contracts and loan contracts convertible into equity as contracts not requiring the authorisation of NBH. This would essentially create the Hungarian legal basis for SAFE, hopefully replacing in the long run the over-complicated venture capital investment contracts.
The ultimate goal, however, to create the automatism of conversion, would only be possible by putting SAFE contracts in the Civil Code. This is still to be done. However, even the adoption of the current proposal would be a giant step towards the widespread adoption of SAFE contracts in Hungary. And then one can hope that the legislator will want to complete the process thus started.