Is SAFE document Equity Conversion Shariah Compliant?
Many startups are using SAFE (Simple Agreement for Future Equity) documents to fund initial capital raises for their companies. This article is a live draft, one I will update with my research, references, and future explanation on this topic from time to time. If you notice anything missing, please check back from time to time for updates. This is an attempt to accurately depict how these documents should be conceptualized under Islamic law, and to determine if the equity conversion in SAFE documents is Shariah compliant.
Summary: SAFE documents are not loans. They are warrants for future equity. The structure found in the SAFE agreement for equity conversion is permissible and offers a viable, interest-free solution to early stage funding for Shariah compliance minded investors.
First, what are SAFE documents?
SAFE or Simple Agreement for Future Equity is defined as a financing contract that may be used by a startup company to raise capital in its seed financing rounds. It gives the investor the right to receive equity of the company on certain triggering events, such as future equity financing or the sale of the company. The price of the equity on conversion is lower than the price of the securities issued to other investors, based on either a: Discount rate or a Valuation cap. SAFE has no maturity date and no accruing interest. Investors receive only a right to convert their SAFEs into equity at a lower price than the investors in the subsequent financing. (Source: Thomson Reuters Practical Law)
There are four versions of the post-money safe intended for use by US companies, plus an optional side letter.
- Safe: Valuation Cap, no Discount
- Safe: Discount, no Valuation Cap
- Safe: Valuation Cap and Discount
- Safe: MFN, no Valuation Cap, no Discount
While these versions all differ as to how dilutive final pricing of shares will be on the SAFE investors final share price, they all agree on the basic mechanics of what happens if and when there is a conversion. As the SAFE user guide states “The biggest advantage of the post-money safe is that the amount of ownership sold is immediately transparent and calculable for both the founder and the investor.” (Quick Start Guide)
What’s the difference between a SAFE and a convertible note?
There are several differences* between the SAFE documents and convertible notes:
- Form of contract: A convertible note is debt, while a SAFE is a convertible security that is not debt. Instead, a SAFE is defined as a warrant.
- Conditions: Convertible notes include an interest rate and maturity rate, while a SAFE does not.
- Complexity: The SAFE is simpler and shorter than most convertible notes.
- Conversion Points: While both convert to equity, SAFE docs only convert to the next round, while Convertible notes convert into a current or future round.
- Early Exit: The SAFE gives the investor the choice of a 1x payout or conversion into equity at the cap amount. Convertible notes typically have a 2x payout.
- Maturity: The SAFE is not a debt, and therefore has no maturity date, unlike the convertible note. This is of considerable importance, because at maturity, a convertible debt’s principal and interest must be repaid or the debt converted into equity.
What Question are we Trying to Answer Here?
So while both of these instruments result in a conversion of value contributed to equity, they are not from the outset the same. A convertible note is a loan at interest unless it is converted to equity. A SAFE is a warrant to buy equity at unit price agreed upon in the future.
This raises the question then: Is this type of sale, where an investor purchases equity for a total price even though the number of individual units and their price has not yet been determined?
In simpler terms: can I sell something for a unit price that I have not yet set, but will, once something else happens?
Selling something for a future determined price
For a sale to be permissible under Islamic law, several conditions must be fulfilled. One such condition is that the sales price must be known to both parties of the contract and specified. That the price is known is relative to Market custom and the context of the sale. This relativity brought about variant opinions as to what extent must the sales price be determined in order for the sale to be valid. one such issue in classical Islamic legal text is a sale dependent on a future price or a customary price. an example of this would be for a person to say sell me this item at market price or sell me this item for the price you sold it to other customers.
Is this a valid means for pricing Equity under Islamic law?
Classically, Scholars held varying opinions about this method of pricing. Well they all agreed that if a principal designates an agent to buy and sell on his behalf essentially making the sales price a Known Unknown that this would be permissible. the question then is when the principal himself designates a price in this manner is it also permissible?
The first opinion, being the official opinion of the Maliki, and Shafi schools, and the more popular of two opinions in the Hanbali school, is that such unit pricing is not permitted. The Hanafi school also did not permit this when applied to non-fungible items.
These scholars held that such a sale was included in the Prophetic prohibition of Gharar, or excessive uncertainty in sales.
The second opinion is that selling an item for a yet to be determined unit price is permitted. The was the opinion of the Hanafi school with regards to fungibles, and for all unit pricing (regardless of whether it is fungible or non-fungible) is was regarded as valid in a narration from Imam Ahmad, a weak position in the Shafi school, and the selections of Ibn Taymiya and Ibn al-Qayyim.
In support of this opinion, they cite numerous evidences, namely that Allah permits contract and specifically contract with due consideration. And while the individual unit price has not been determined, the overall price for sale has been determined, and pricing per unit – while unknown at the time of contract – results in a known price once a predetermined event occurs.
For example, saying “I’ll buy $50 dollars worth of this item at closing market price or at the price that Zaid pays for it or your median monthly price” this would be valid, because these prices – while relatively unknown at the time – are knowable and determinable. So the uncertainty of this transaction is only relative to the time between contracting and that predetermined event, and therefore is not significant enough to invalid the sale. Therefore the argument that prohibited Gharar applies here is incorrect.
Likewise, several other contracts under Islamic law allow for the sale of an asset or service without first determining the final unit value. For example, hiring a wet nurse to breast feed one’s child was common practice in early Islam, and while a monthly employment price was determined, the number of individual times a baby would be allowed to suckle would not.
Similarly, custom in Muslim lands from the earliest times allowed a person to buy from a seller bread or meat or other staple goods, every day picking up an amount needed and not paying until the end of the month, essentially leaving the price as indeterminate until the end of the month when accounts were settled.
Another precedent for this is in marriage. When a bride-purse is offered to a woman for her hand in marriage, is it permissible by consensus for her to agree to a bride-purse amount that is customary, even if that customary amount is not known at the time of the marriage contract. Because it can be determined, it is allowed. To allow such a thing to happen in marriage, which typically warrants strict conditions, and not allow it in sales, which typically does not, is the opposite of what the Shariah evidences for these types of transactions. There are numerous other precedents for this as well, but I’ll suffice with mentioning these.
Conclusion: SAFE Document Equity Conversion is Shariah Compliant
SAFE documents are not loans. They are warrants for future equity. Anyone who signs a SAFE agreement is essentially saying to the company he or she is signing the agreement with “I agree to buy shares of your company in the amount of X dollars for the unit price agreed to when either a) equity funding or b) a liquidation event occurs, else you will return to me the full value of my purchase.”
The custom and convention of the Sharia is to treat like-issues similarly and to differentiate between disparate issues, all with justice and equity. This form of sale is in line with the types of sales for yet to be determined unit prices above according to what is perhaps the stronger of the two above state opinions, and therefore this structure found in the SAFE agreement is permissible and offers a viable, interest-free solution to early stage funding for Shariah compliance minded investors.
A Final Note
As a final note, this article should not be construed as a validation of the SAFE documents in their entirety, as there may be other issues in need of research and possible amendment. This article only deals with the overall structure of the SAFE documents and how they convert to equity which is – in the opinion of this author – permissible.
And Allah knows best.