Tax treatment of a simple agreement for future equity is not a lock
TAX BLOG |
Developed in 2013, a start-up-friendly funding mechanism called the simple agreement for future equity (SAFE) was conceived as a substitute for convertible debt. Perhaps you are one of the many investors who have purchased SAFE interests in start-ups.
Because a SAFE’s features differ from those of more traditional debt and equity interests, the tax treatment of a SAFE may be unclear. There are a few details every SAFE owner should know:
- A SAFE typically is not debt under state law because it lacks both a maturity date and an interest rate
- A SAFE typically converts automatically to stock (or other equity) during the company’s next equity financing (conversion can also occur upon sale of the company)
- If there is no sale or equity round, the SAFE holder typically has no rights to payment except a liquidation preference for its original investment amount
- Like warrants and convertible debt, most SAFEs clearly are derivatives of the company’s equity
- Like debt or preferred stock, however, they may also carry repayment rights
Answering the question of whether a SAFE should be treated as debt, equity or an equity derivative for tax purposes involves weighing these legal rights in the context of the specific facts and circumstances.
Because the SAFE’s tax characterization may affect the tax treatment of transactions such as fundraisings, sales and business combinations, you should consult with your tax advisors about the proper tax treatment of your SAFE arrangements.