The Startup Guide to Simple Agreement for Future Equity Tax Treatment

If it Resembles Equity and Functions Like Equity, it’s Likely Equity

Simple Agreements for Future Equity (SAFEs), introduced by Y-Combinator in 2013, are a commonly used form of investment for early-stage startups. Y-Combinator designed SAFEs to require minimal negotiation. However, simple agreement for future equity tax treatment is less straightforward than their name implies.

Startups often view SAFEs as preferable to convertible debt or priced equity rounds at the earliest stages. SAFEs avoid interest payments or maturity dates, only converting upon a later equity round or sale. There is a general perception that using SAFEs minimizes costs and complexity. Some investors also prefer SAFEs to debt since they offer equity upside without debt’s downside protection. While not the focus here, founders should understand SAFEs’ impact on their capitalization table post-conversion to avoid surprises later. Savvy early investors know their post-conversion ownership; founders are wise to do the math upfront.

In basic terms, investors pay for the SAFE, which then converts to shares in a later equity round. SAFEs commonly include valuation caps and/or discounts determining the conversion price per share. For example, with a cap, the conversion price cannot exceed that valuation. Discounts let investors choose the better of discount or cap prices.

If a liquidity event precedes conversion, investors can choose cash equaling their investment (adjusted if insufficient funds) or equity. On dissolution while outstanding, SAFEs recover investment before equity, after debt. Thus SAFE holders primarily seek upside, likely writing off investments in down scenarios without creditor rights.

While SAFE terms disclaim debt, their proper simple agreement for future equity tax treatment remains unclear, overlooked by many. Depending on terms and circumstances, SAFEs may constitute equity or prepaid variable forwards. The tax complexity contradicts SAFEs’ intended simplicity.

Simple Agreement for Future Equity Tax Treatment is Not as Debt

The taxation of simple financial instruments tends to follow clear guidelines, but more complex cases can generate uncertainty.

Debt instruments traditionally involve fixed repayment schedules and arm’s-length interest rates. Equity provides ownership stakes that appreciate with company success but carry greater risk. Some hybrid instruments share traits of both.

SAFEs were designed as alternatives to convertible debt. While convertibles may sometimes resemble equity, SAFEs seem to fall squarely in that category. The holder assumes equity-like risks with no guaranteed returns. Repayment amounts and timing remain uncertain, depending on the company’s performance.

Tax authorities evaluate multiple factors when classifying instruments, but flexible repayment schedules often indicate equity over debt. As owners, equity holders profit from company growth, whereas lenders earn interest over time. Instruments that enable profit-sharing look more like equity, even if labeled “debt”.

SAFEs lack the primary benefits of fixed-income securities. No maturity dates or unconditional principal/interest exist. Payouts depend on contingencies, and the instruments subordinate to debt. In these scenarios, the parties clearly did not intend to create debt obligations.

In complex cases, tax classification requires considering economic substance over form. By prioritizing flexibility and upside over guaranteed returns, SAFEs seem designed to participate in ownership, not lending. Their equity-like economic role suggests simple agreement for future equity tax treatment is as equity.

Is a SAFE a Derivative or Equity?

If a simple agreement for future equity tax treatment is not as debt, then what is it? Depending on the specific terms and circumstances, a SAFE seems likely to be either a prepaid forward contract or a current equity grant. As I will explain further, in many cases the more appropriate treatment is as a prepaid forward contract.

Simple Agreement for Future Equity Tax Treatment as a Prepaid Forward Contract

A forward contract involves agreeing to purchase a fixed quantity of property at a fixed price in the future. With a variable prepaid forward contract, the buyer pays the seller up front rather than on the delivery date, and a variable amount of property is transferred when the contract closes. A SAFE resembles such a contract, as the investor purchases equity (with cash or services) under a contract specifying a quantity of property to be delivered later, varying based on circumstances.

Generally with a prepaid forward contract, the “seller” is not treated as selling the underlying property when entering the contract. Instead, the sale happens when delivery occurs. The contract remains open, with tax consequences delayed until closing—when the property is delivered. Accordingly, if a SAFE is treated as a variable prepaid forward contract, the investor’s purchase and the company’s receipt should not be taxable events for either party. The prepayment is an advance deposit without immediate tax effects. When actual equity shares are received under the SAFE, neither party has a taxable event. The investor takes a cost basis in the stock equal to the prepayment, and their holding period begins upon receipt. Later disposition triggers capital gain/loss for the investor based on prepayment versus sale proceeds.

The IRS has respected variable prepaid forward contracts over treated sales if: (1) the taxpayer received fixed cash, (2) entered an agreement to deliver a number of shares varying significantly with share value on the exchange date, (3) pledged maximum deliverable shares, (4) retained legal right to substitute cash/shares, and (5) was not compelled to deliver pledged shares on maturity. The IRS focused on retained dividend/voting rights and lack of required delivery. In typical SAFE arrangements, the company receives fixed cash and agrees to later deliver shares or cash varying with share value—and investors lack dividend/voting rights until delivery. So ownership benefits and burdens likely have not transferred to the investor.

The Certainty of Conversion and Equity Treatment

When considering the appropriate simple agreement for future equity tax treatment, two factors stand out. The first is the likelihood that the SAFE will convert to shares of stock based on the circumstances surrounding its issuance. If conversion is nearly guaranteed to occur soon after issuance, the SAFE begins to resemble equity rather than a derivative security.

The second important factor is timing. If the SAFE is treated as an upfront equity grant, the investor’s holding period for the underlying stock begins on the SAFE purchase date. This “equity clock” can provide substantial future benefits depending on how long the stock is held. For example, a long holding period may allow gains to qualify as long-term capital gains or take advantage of exemptions for qualified small business stock.

While SAFEs aim to be straightforward, complexity often emerges later rather than during issuance. An overlooked issue is how SAFEs affect the tax treatment of future gains. Unless a SAFE starts the equity clock immediately, investors risk forfeiting tax benefits that require years of ownership (e.g., IRC Section 1202). Both issuers and investors would be wise to discuss the tax implications upfront based on each SAFE’s unique circumstances. While SAFEs are not debt, clarity around their equity status aids understanding of future tax consequences. Careful consideration of conversion likelihood and timing factors can help determine the appropriate approach.

Simple Agreement For Future Equity Tax Treatment Implications

Whether a SAFE is properly considered a variable forward contract or equity can have meaningful tax consequences for both the company and investor. If a SAFE is a prepaid variable forward contract, the company is not treated as issuing stock to the holder until a triggering event occurs, such as a later financing round. Only then would the company exchange property (i.e. stock) for the investment.

In contrast, if the SAFE is immediately treated as equity, the investor holds a deemed ownership in the company from the initial investment date for tax purposes. This difference in characterization can impact situations like determining long-term capital gains treatment for any later stock sale. The holding period for favorable rates starts only if the SAFE is a forward contract, not equity.

Consider two examples that illustrate these implications:

Example 1:

An investor acquires a Simple Agreement for Future Equity for $10 million in the first year from Startup Y. The subsequent year, as Y attracts further investment, the Investor is allotted shares upon conversion. Assuming the SAFE constitutes a forward contract, the initiation of the shareholding period for the original investor is recognized from the second year. This timing means they are ineligible to claim long-term capital gains tax advantages until the fourth year following a future sale of these shares.

Example 2:

A different investor invests $10 million through a SAFE in the initial year into Startup Y, at a time when its total valuation was $20 million and it reported $10 million in net operating losses (NOLs). In the next year, with the company’s valuation increases to $50 million and the investor converts their SAFE into equity, if the SAFE were considered immediate equity, this would have led to a change in ownership under Section 382 in the first year of the investment. Consequently, this would limit Startup Y’s ability to apply its NOLs, limiting them to an annual cap determined by the company’s lower valuation in the first year.

Does the SAFE Agreement Itself Address the Tax Treatment of the SAFE?

That is a relevant question to consider. Often, the SAFE agreement will address this issue by specifying the the parties agree to treat the instrument as equity for federal tax purposes. This standard language aims to simplify matters. However, complexity can arise because treatment as stock may not always fit the circumstances appropriately. For instance, entities treated as partnerships for tax purposes sometimes include this standard stock language within their SAFE agreements. Yet that language would clearly be incorrect in those cases, since a business cannot be regarded as issuing stock for tax purposes if it operates as a partnership rather than a corporation.

In conclusion, while SAFEs can benefit early-stage companies seeking financing, properly determining a simple agreement for future equity tax treatment is important for both the business and its investors. Given the lack of clear-cut answers, those involved in capital raising would be wise to seek guidance from tax experts to consider any potential tax implications before finalizing SAFE financing agreements.

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President & CEO

Chris co-founded Eton Venture Services in 2010 to provide mission-critical valuations to venture-based companies. He works closely with each client’s leadership team, board of directors, internal / external counsel, and independent auditor to develop detailed financial models and create accurate, audit-proof valuations.

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