SAFE Notes under German Law - Key Considerations for Start-ups and Investors

As Carta's newest data clearly shows, Simple Agreements for Future Equity, or SAFE for short (available on Y Combinator's website at https://www.ycombinator.com/documents), remain the standard legal document for early-stage startup financing in the U.S.

With a SAFE, the investor provides capital to a startup company as an upfront payment for a future acquisition as part of a round of (equity) financing in which larger amounts of capital are invested in the company’s first ‘proper’ (equity) financing round.?

SAFE Notes are popular in the US for the following reasons:?

• They allow founders to secure funding quickly and cheaply because they are so widely used and accepted in the US ecosystem (thus avoiding the back and forth of what is considered market standard).?
• They allow financing without (a) setting a valuation or (b) giving up control rights, so negotiations over board seats, liquidation preferences, protective provisions and veto/control rights can be deferred to the next priced round.?
• They do not accrue interest and have no maturity date, making them the preferred choice for founders.?
• Instead of forcing investors into a single close, founders can have rolling closes of the SAFE funding round.?

If you would like to learn more about SAFE Notes in general, we can highly recommend Chris Harvey 's recent substack post (see the link below).

In Germany the convertible loan is the most common way of providing cost-efficient and comparatively easy capital to start-ups. This is because a convertible loan agreement offers essentially the same advantages as those mentioned above (except, of course, that the convertible loan is in fact a loan, i.e., it has to be paid back with interest).??

Like SAFE Notes in the US, convertible loans are highly standardized, for example through initiatives such as the template of the German Standards Setting Institute (GESSI - GESSI is a joint venture of the Business Angels Netzwerk Deutschland e. V. (BAND) and the Startup Association.??

Finally, the investment through the convertible loan is also generally eligible for funding through the INVEST grant for venture capital by means of a state subsidy (see the new funding guidelines, available at https://www.bmwk.de/Redaktion/DE/Dossier/invest.html), which contributes to its popularity.?

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So, can SAFE Notes be used to finance a German company??

As far as the YC template is concerned, the short answer is no, as it does not sufficiently reflect a number of peculiarities that arise under German law. So, please, do not use the YC template for a German limited liability company (UG (haftungsbeschr?nkt) or GmbH).?

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But can it be amended to fit German requirements??

The answer is yes, we can. But that does not necessarily mean that you should use the SAFE. In our experience, it is quite a task for a German startup to convince its local investors to use SAFE notes. More often than not, they are not familiar or comfortable with them and have a strong preference for convertible loans. It will simply take too much time and energy. However, if you are raising with US-based investors, it is always worth a try to use the SAFE.? But if you do, please make modifications and at least address the points below:??

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1. Shareholder Approval / Obligation?

?In the US, a SAFE is just an agreement between the company and the investor. In Germany, all shareholders must also be involved. Since the SAFE contains an obligation of the company to issue shares, the shareholders of the startup company must approve the conclusion of the SAFE. They must also undertake to take the necessary actions and measures to issue the shares at the time of the conversion of the SAFE (see below). This can be addressed by shareholders becoming parties to the SAFE and co-signing it.??

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However, from the perspective of international investors, a co-signature by all shareholders would seem rather unusual. To avoid shareholders becoming parties to the SAFE, a separate short-form conversion agreement can be entered into between the shareholders and the company. Such an agreement would include a shareholder resolution approving the execution of the SAFE and an obligation to cooperate with an investor's conversion request to enable the company to perform its obligation under the SAFE. Such an agreement may be entered into in advance and attached to the SAFE.?

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2. Conversion Mechanism?

?The US conversion mechanism does not work in a German company. We have to include provisions for the capital increase under German law and the like. This looks like a small change, but it is in fact the most complex part of the amendment.?

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3. Choice of Law

From a start-up perspective, it is preferable to use German law for reasons of legal certainty. Nevertheless, it seems feasible to use U.S. law as a basis, since German corporate law (which is particularly relevant to the conversion and the future shareholder status of the investor) is likely to remain applicable despite the choice of U.S. law.?

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4. Notarization?

As with convertible loans, the question arises as to whether notarization is required for SAFEs. If a court decides that notarization is indeed necessary, the entire SAFE (including the subordination clause, see below) would be invalid, resulting in an immediate repayment obligation, which would most likely lead to the insolvency of the start-up and the potential personal liability of the managing directors. Therefore, when using a SAFE in Germany, at least the following should be considered:?

Some say that notarization is required because of the obligation contained in a convertible loan or SAFE to issue new shares in the event of a future conversion. Although the issue has not yet been decided by the German Federal Court, the prevailing view in the literature is that notarization is not required.??

Others say that convertible instruments such as convertible loans or SAFEs generally contain an obligation to enter into a shareholders' agreement between the shareholders in the event of conversion. This is to prevent an investor from becoming a shareholder without being subject to the provisions of the shareholders’ agreement. To the extent that the shareholders' agreement itself contains elements that must be notarized (e.g., a drag along obligation), a notarization obligation is likely. However, the risk of a notarization obligation can be reduced by drafting the SAFE in a specific manner (for instance, by making the accession not as a legal obligation but a condition to the conversion).??

?To be clear, notarizing the SAFE is the safest way. If you want to avoid notarizing the SAFE, the investor's signature should at least be certified (beglaubigt). Also, the SAFE should be drafted in such a way as to make notarization/certification less likely, and a separate subordination agreement should be executed.?

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5. Qualified Subordination?

?German convertible loans always come with a so-called qualified subordination clause in order to avoid over-indebtedness as the money runs out. As there is still uncertainty how to treat a SAFE from a balance sheet perspective (debt or equity), the best way would be to include such a a subordination clause in a German SAFE for good measure.?

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If you are a startup or investor considering using a SAFE note in Germany, or would like to discuss the above, please feel free to contact Christian Musfeldt or Manuel Nikoleyczik on Linkedin or via email ([email protected]).

Disclaimer: The article is neither legal advice nor an academic discussion of the relevant legal issues, so it is not intended to be an exhaustive resource, and other factors may apply to your specific situation. Rather, it is intended to inform founders and investors of the important legal aspects to consider when using a SAFE Note under German law. You are strongly advised to seek the advice of legal counsel (like us) to ensure compliance with the issues discussed above.?