A simple agreement for future equity (SAFE) is a financing agreement that has become increasingly popular among startups and more mature companies in recent years. Introduced as a startup investment accelerator in late 2013, a SAFE is a contract that grants investors the right to future equity in a company upon certain trigger events, such as a sale or another financing round, without determining a specific price per share at the time of investment.
What is it?
In exchange for investing money in a company, an investor receives a SAFE that gives them the right to convert their investment into equity in the company, or cash, at a future date, often upon an equity financing round or liquidation event. The conversion terms, such as the company’s valuation, are typically specified in the SAFE.
There are several benefits to using a SAFE, including:
- Simplicity: SAFEs are relatively simple to negotiate and implement compared to other types of investment agreements, such as warrants, convertible notes or preferred stock.
- Flexibility: SAFEs can often be tailored to meet the specific needs of the company and the investor.
Drawbacks to using a SAFE may include:
- Lack of Control: SAFE investors typically do not have any voting rights or other control rights in the company.
- Potential Dilution: SAFE investors can face dilution if the company raises additional capital at a higher valuation.
- Uncertainty of Conversion: SAFE investors may not be able to convert their SAFE into equity if the company does not experience a triggering event.
- Uncertain Income Tax Consequences: Because the IRS has not provided definitive guidance on SAFEs, their tax treatment and resulting consequences are uncertain.
TAX CONSEQUENCES OF SAFE INVESTMENTS
To date, there is no definitive IRS guidance on the income tax treatment of SAFEs. For income tax purposes, taxpayers have usually classified SAFEs as debt, equity or prepaid forward contracts.
With respect to debt or equity classifications, SAFEs lack many of the indicia of true debt or equity instruments. For example, compared to debt, a SAFE typically does not have a repayment obligation, interest accruals, creditor rights or a maturity date. When compared to equity, a SAFE investment does not have dividend rights or voting rights. The classification of a SAFE as equity, however, may be warranted if it appears certain that the SAFE investment will convert to equity, or if other conditions are met.
For income tax purposes, and depending on the facts, the most appropriate classification for a SAFE may be the equivalent of a variable prepaid forward contract to purchase equity. SAFEs are often economically similar to a prepaid forward contract. In a forward contract, one party commits to purchasing from a counterparty a fixed amount of property at a fixed price at a future date. Forward contracts can include prepaid terms, for example, the purchase price is paid upon execution. It may also include postpaid terms, where the purchase price is paid upon settlement.
In contrast to SAFEs, the IRS has provided guidance on the tax treatment of variable prepaid forward contracts. For income tax purposes, forward contracts are usually treated as “open transactions.” That is, any tax consequences to the parties do not occur when the contract is originated but when the transaction is concluded. Prepaid amounts under a forward contract usually do not alter its general tax treatment.
In most settings, a SAFE holder does not recognize taxable income until the SAFE is converted to cash, equity or some other asset. Since each SAFE transaction is unique, we recommend taxpayers consult with an experienced tax advisor prior to investing in SAFEs or engaging in trigger transactions which may result in unforeseen tax consequences.
There are three main ways to classify a SAFE when it comes to taxes. They are either:
(2) an equity derivative, like a forward, or
(3) an equity ownership.
To determine the classification that applies to a particular SAFE instrument, one must look at the facts and circumstances of the specific situation.
First, SAFEs are usually not debt because they don’t have the economics that loans typically have, namely, a promise to pay back and an interest rate. In addition, with a SAFE, you can get more share ownership if the company does well. Further, if the company goes bankrupt, SAFE holders do not have a senior claim that debt holders would benefit from.
Second, it is important to note that holding SAFEs are not the same as owning part of the company. Even though SAFEs give the holder some rights if the company shuts down, they often don’t provide other rights that an owner would have, such as voting rights, the right to dividends, and the right to share in profits or losses.
Below we discuss the two most likely treatments for tax purposes upon the issuance of SAFEs.
SAFES TREATED A FORWARD CONTRACT
In many cases, it makes sense to treat a SAFE as a contract that lets you buy part of the company later – a forward contract. You pay now for a future right and get shares later when a transaction occurs, such as a qualified financing or liquidity event. The number of shares you receive depends on the company’s valuation at that time. This is especially true for pre-money SAFEs, where you agree on a price upfront and are then issued shares later based on how the company is valued when a triggering event occurs.
In the context of being treated as a forward contract, for a ‘variable prepaid forward contract’ tax treatment, there are no immediate tax consequences for the company or the investor when initially issuing a SAFE. The SAFE is not considered an equity issuance or ownership in the company. Proceeds from investors are simply considered a liability on the company’s balance sheet, and there is no taxable event at this stage. Rev. Rul. 78-182, 1978-1 C.B. 265. Furthermore, the later issuance of shares to fulfill the SAFE contract is also tax-free. Section 1032(a). See Chief Counsel Advice Memorandum 201025047 (3/22/2010). The downside of this treatment is that the holding period of the investors’ equity interest would be delayed until conversion on the triggering date.
SAFES TREATED AS EQUITY
An alternative tax treatment would be to treat the SAFE as an equity grant, owning part of the company (shares of stock) for tax purposes. This is more likely for post-money SAFEs than pre-money SAFEs because a post-money SAFE provides more certainty regarding the ultimate ownership percentage in the company that the investor will get.
The more certain (based on the current economics of the company) that the SAFE would turn into shares of the company, the better the case for treating the SAFE as equity of the company. For example, if you purchase the SAFE when the company is about to raise more money (and so your SAFE will turn into shares imminently), it’s more like you received equity shares right away than if you were holding a forward contract.
If you pay for the SAFE and treat it as equity of the company, then the capital gain holding period will begin the day you bought the SAFE, which can result in a tax benefit depending on when there is a realization event for the shares.
Forward contract vs. stock- which treatment is more appropriate? Consider the following:
- What is the likelihood that the SAFE will convert to shares? When you sign the SAFE, will there be an upcoming transaction that converts the SAFE turn into shares? For example, if there is already a plan, pending deal, or a serious talk to raise more money, sell the company, or another event that triggers the SAFE conversion, then it’s more likely that your SAFE holdings will convert to shares and, therefore, treating the SAFE as equity may be more appropriate.
- Do you have any control over the company? Do you have any voting rights or power to choose who runs the company or makes decisions? Do you have any insight into the number of shares you will be issued? If you already know how many shares you will get when you buy the SAFE, then it’s more like stock. If you do not know and it depends on how much the company is worth when there is a future transaction, then it is more like a forward contract. However, if you have some advantages in receiving more shares (like a discount or a cap), and you will likely get shares, then treating the SAFE as equity may be more appropriate.
SAFEs were designed to be easy documents to understand and are intended to be used for fundraising quickly. However, the tricky parts might show up after you purchase the SAFE. It is important to evaluate the tax consequences of being treated as a forward contract or an equity grant before issuance. This may not be possible in every situation. If a SAFE is not treated as a piece of the company right away, you are putting off the time you need to start counting for long-term capital gains and qualified small business stock ‘QSBS’ treatment, which could mean foregoing big tax savings depending on the timing of a future sale.
SAFES: STREAMLINING STARTUP FINANCE
For investors, SAFEs provide access to high-growth startups along with future discount and cap advantages. Further, the simplified process saves legal time and costs associated with a priced round. Using SAFE agreements, both startups and investors can execute deals quicker. However, the classification of SAFEs upon issuance is important when it comes to tax reporting, as there can be substantial tax ramifications depending on how the instrument is classified- derivative vs equity.