Editor’s note: This is a guest post by Jaakko Lindgren and Laura Pirhonen, Castrén & Snellman Attorneys Ltd

Freedom of contract as a main rule in contractual relationships provides for a large variety of options in startup financing. Instruments combining attributes of both equity and debt – which may also be called hybrid or mezzanine instruments – may help to balance the risks and yields of an investment to a level suitable for both parties, but at the same time with financial evaluation one must remember to make important legal considerations. These include e.g. legal issues relating to accounting, corporate law and taxation. An arrangement, which might be flexible and efficient from the point of view of financing, accounting and taxation, might be hard to comply with from corporate law point of view. In the following post we will briefly discuss convertible notes and an instrument called ”SAFE” – a recent financial innovation by yCombinator – from corporate law perspective.

From Finnish corporate law’s point of view, hybrid instruments basically differ from pure equity or debt instruments in their distribution and control rights, payment priorities, liquidation and dilution preferences and perpetuality.

Convertible note (In Finnish: vaihtovelkakirjalaina) is basically a loan, for which a set of events and/or due dates are determined to launch a conversion into company shares. From Finnish legal point of view, it is a matter of setting off the creditor’s receivable against the subscription price of the shares. One must bear in mind, as stated in the very beginning, that even an instrument called ”convertible note” is not unambiguous, since the terms and conditions can be negotiated individually based on the freedom of contract -principle. In case of convertible notes, the instrument usually has determined interest, which is paid prior to any dividend distributions to equity holders. It also has better liquidation preference than equity, and contrary to equity, the loan usually has a maturity date, if the conversion is not launched early enough according to the terms.

Startup financial professionals have found some features of convertible notes problematic. Maturity date may cause a threat of insolvency, and calculations relating to accruing interest may increase transaction costs. Another related problem with the convertible notes has been the issue concerning pre-determined valuation of a company, which may prove to be a hard task to negotiate. YCombinator has now tried to address these problems by developing a new instrument called “SAFE” (“Simple Agreement for Future Equity”).

SAFE comes in different variations, but the basic idea is to improve convertible note by using either a valuation cap or a discount rate, or a combination of these two methods, when entering into the financing contract, in order to avoid the valuation related problems in the early stages of the company. The instruments do not carry interest and they have an element of perpetuity, since there is no actual maturity date, but only determined events may launch the conversion or repayment. According to the SAFE agreement, SAFE entitles its holder to convert the instrument into “preferred SAFE shares”, which is a separate share class from the common stock of the company. The conversion is structured in a manner, which takes into account multiple variables, such as the valuation cap and/or discount rate, pre-money valuation of the company and company or liquidation capitalization (fully diluted outstanding capital stock with certain adjustments depending on the event launching the conversion). The goal of developing SAFE is to provide a more flexible instrument to early stage financing, which would lower the transaction costs and speed up the process.

Pursuant to the Finnish Companies Act (624/2006, “FCA”), a convertible note – as well as SAFE – is ”a special right entitling to shares”. Provisions regarding these special rights require certain measures in decision-making concerning the issue of the special rights and further compliance with FCA when applying for register entries to the Finnish Trade Register. The key issue from the FCA’s perspective is to determine the conversion rates, amounts and allocation in a manner, which complies with the provisions of the chapter 10 of the said Act and is eligible for registration. If an instrument is structured in a highly sophisticated manner, this might require mathematical equations or large tables to be presented and included in the decisions concerning the issuance of special rights, which in turn may result in high transaction costs and thus make an instrument unsuitable for small investments. Also the separate share classes required for SAFE conversion must be established in compliance with the FCA. Altogether SAFE is not recommendable for small startup investments due to the high transaction costs of FCA compliance and registrations, caused by the various scenarios and variables included in the instrument. However, simplifying the terms and conditions of the instrument or standardizing the documentation relating to the above mentioned compliance procedures might change this evaluation.

In conclusion hybrid instruments may provide much needed flexibility in startup financing, but legal pitfalls must be taken into careful consideration. Instruments developed in other countries may not be suitable for Finnish purposes as such. However, we encourage startup companies and investors to investigate the possibilities of convertible notes and other hybrid instruments, since they are an efficient tool in balancing the risks and the yields of an investment.

Please join us in Startup Helsinki Meetup January 9, 2014 at 6 p.m. in Painobaari, Postikuja 2, Helsinki to find out more and discuss the topic in more detail.