Updated. Originally posted September 14, 2019.
Once there was a beautiful tech incubator named Y Combinator. In a dream one night she saw herself curing every start-up’s funding woes with a magical new creature called a SAFE.
When she woke up, she got to work creating this new instrument. SAFE would stand for “simple agreement for future equity” she told everyone. SAFEs would allow a company to take in money without having to determine a specific price per share at the time of the investment. Before she knew it, everyone was using them.
Suddenly the world turned dark and it started snowing ashes. As it turns out, we were all in the upside down. Screaming ensued as we realized, a SAFE isn’t a magical unicorn, it’s the demogorgon…
Kidding aside, from 2013-2018, the reason I didn’t love SAFEs was simply because no one knew what they were for tax purposes. Were they debt? Equity? A warrant? Each of those is treated differently for tax purposes, so it was difficult to predict or plan for the tax consequences.
Y combinator has started treating SAFEs as equity from day one and I see language like the below now in almost every C corporation SAFE.
- The parties acknowledge and agree that for United States federal and state income tax purposes this SAFE is, and at all time has been, intended to be characterized as stock, and more particularly as common stock for purposes of Sections 304, 305, 306, 354, 368, 1036 and 1202 of the Internal Revenue Code of 1986, as amended Accordingly, the parties agree to treat this SAFE consistent with the forgoing intend for all United States federal and state income tax purposes (including, without limitation, on their respective tax returns or other information statements).
It strikes me as a bit odd to consider something called a “simple agreement for future equity” as equity on day one. That said, I do prefer this from a tax perspective, at least in the C corporation context. It arguably starts the long-term capital gains holding period and the qualified small business stock (QSBS) holding period, if applicable.
Note that as equity, I think the cash received by the company affects the value of the company for purposes of issuing options, etc., more so than pure debt. I expect a valuation firm would need to consider what rights the SAFE would have above that of the common.
To be clear, merely including language stating an intent to treat a SAFE as equity does not guarantee the Internal Revenue Service will agree. To my knowledge, the IRS has not weighed in on this yet and the terms of each SAFE varies so one SAFE may look more like equity than the next. But I do think you have a better chance of having form respected when the intent is stated and followed from the outset.
Prior to 2019 SAFEs were rarely used in LLCs taxed as partnerships. One problem was that if you treat a SAFE as equity in an LLC taxed as a partnership, the SAFE holder should be allocated income or loss in some fashion and should receive a K-1. Not so simple after all, right?
During the last several years, SAFEs in LLCs taxed as partnerships have become increasingly common. And in a very self-serving fashion, people tend to take an alternative position as to the tax treatment of SAFEs in that context. Instead of characterizing the SAFE as equity for tax purposes, they include language like the below characterizing the SAFE as a noncompensatory option:
- The Investor acknowledges that there are no relevant authorities that directly address the U.S. federal income tax treatment of this SAFE or the Securities, and no ruling has been sought from the Internal Revenue Service (IRS) in connection with the issuance of this SAFE or the Securities. Accordingly, the U.S. federal income tax characterization of this SAFE and the Securities is uncertain. However, the Company and the Investor agree to take the position that this SAFE will be treated for U.S. federal income tax purposes as a non-compensatory option as defined in Treasury Reg. Section 1.721-2(f), but shall not be treated as exercised upon issuance. Therefore, the Investor shall not be treated as a member of the Company, and shall not receive any allocation of income, gain, loss or deduction in respect of any Units issuable upon the conversion of this SAFE until, if ever, such Units are actually issued following such conversion. The Investor agrees to not take any position inconsistent with the foregoing intended tax characterization of this SAFE on any tax return, in any administrative or judicial proceeding relating to taxes, or otherwise, unless required by the Company or by a final determination within the meaning of Section 1313 of the Internal Revenue Code of 1986, as amended (the “Code”). The Investor acknowledges that there can be no assurance that the IRS will agree with such characterization and that a different characterization may affect the tax consequences of this SAFE to the Company and/or the Investor. If the Company determines that this SAFE should no longer be characterized as a non-compensatory option, the Investor shall cooperate with the Company, and shall execute and deliver such additional amendments and other documents as the Company requests, to restructure this SAFE in a manner determined by the Company, provided that such restructuring provides reasonably equivalent economic benefits to the Investor as this SAFE. The Investor has reviewed with its own tax advisors the federal, state, and local tax consequences of this investment, where applicable, and the transactions contemplated by this SAFE. The Investor is relying solely on such advisors and not on any statements or representations of the Company or any of its agents and understands that the Investor (and not the Company) shall be responsible for the Investor’s own tax liability that may arise as a result of this investment and the transactions contemplated by this SAFE.
Note that there is a risk that the noncompensatory option rules would require the SAFE be treated as equity anyway, so there can be a disconnect between how the company is reporting the SAFE and how the IRS might view it.
Also, I have a concern that the company might have taxable income if the SAFE is converted directly into a C corp SAFE at an LLC to C corp conversion, rather than being converted into partnership equity first.[1] So if you go the noncompensatory option route, here’s some sample conversion language you might consider putting in the SAFE:
- In the event of a Conversion Event, the parties hereto acknowledge and agree that this Safe shall, at the election of the Company, be automatically converted into a number of Preferred Units of the Company equal to the Purchase Amount divided by the Liquidity Price (the “Conversion Units”) immediately prior to the consummation of such Conversion Event. Any Conversion Units issued to the Investor pursuant to this Section 1(e) shall be exchangeable in any such Conversion Event at the election of the Company, into a standard form of Post-Money Valuation Cap Simple Agreement for Future Equity (version 1.2 or such later version agreed by the parties) published by Y Combinator, with such changes as reasonably necessary require to adapt this Safe to such standard form. The Manager’s determination of such adaptation, on advice of legal counsel, shall be final and binding on the parties. The parties agree cooperate in good faith to execute any documents necessary in connection with the Conversion Event.
Final word of warning: Do not use SAFEs in an S corp. If a SAFE is equity, it will almost certainly violate the one class of stock requirement.
Mike Baker frequently advises regarding SAFEs. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] Treas. Reg. 1.721-2(d) “Section 721 does not apply to the settlement of a noncompensatory option in cash or property other than a partnership interest in the issuing partnership.”