SAFE tax treatment is an important consideration for investors looking to finance startup businesses and their founding members. Simple Agreements for Future Equity, or SAFE notes, offer an alternative to convertible notes by allowing investors to convert their investment into equity at a later date. However, the tax implications of this investment instrument are complex.
Understanding the role SAFE notes play in startup funding is essential in order to use them favorably. Work with a tax expert to identify taxable events and ensure compliance.
SAFE Notes Basics
SAFE notes serve as a contract between a startup and an investor. They offer the future right to a variable number of stocks or shares. This right typically converts into equity during a future financing round, often at a discounted price or based on a valuation cap. Early investors are therefore rewarded for taking on the initial risk of early investment.
Issuing SAFEs is appealing for startup founders as they receive a cash investment in return. Furthermore, their terms tend to be more favorable to the startup than issuing convertible debt. This is because SAFEs don’t have debt features like a maturity date, specific interest rates, or default provisions.
However, issuing SAFE notes comes with several caveats that founders must take into account. Consult an expert in startup CPA services early to reduce your risk of compliance setbacks or IRS audits.
Key Features of SAFE Notes
SAFE notes have two features that distinguish them as a unique investment instrument: their valuation cap and their discount rate.
Valuation Cap
A valuation cap establishes the maximum value at which your backers’ investments convert into equity. In other words, it protects early investors by granting them equity as if they’d invested at a lower valuation. This low valuation endures even if the company raises its value at subsequent pricing rounds.
Discount Rate
Early investors’ SAFE notes convert into equity at a discounted price when compared to investors that join during later financing rounds. This offers a great incentive for early-stage investment.
Different Types of SAFE
Different types of SAFE are primarily distinguished by how they handle valuation adjustments:
- Valuation Cap Only: The investor converts at the valuation cap or the actual round valuation, whichever is lower.
- Discount Only: The investor receives a percentage discount on the next round’s price per share.
- Valuation Cap and Discount: The investor receives the more favorable of the two.
- Most Favored Nation: The investor benefits from better terms granted to future SAFE holders.
Investors must also determine if the SAFE uses a pre-money or post-money valuation cap. Be aware that post-money SAFEs are the modern standard and offer investors more transparency regarding how much of the company they’ll own post-conversion.
How SAFE Notes Are Taxed
The tax classification of SAFE notes is complex and often requires case-by-case evaluation by a tax professional. This is because their classification for federal income tax purposes isn’t explicitly laid out in the Internal Revenue Code. The upshot is that their treatment often hinges on the terms of each SAFE note and its interpretation under existing tax laws.
SAFEs essentially function as hybrid instruments, as they’re neither equity nor debt. SAFEs fall into a gray area under the tax code, and misclassification may result in reporting errors or unexpected tax liability. This means their tax treatment always requires meticulous expert analysis.
Both founders and investors will benefit from consulting experts to assess the safest way to use SAFE notes for maximum benefit and minimum risk. This is especially true around the time of conversion events and when filing taxes. Investors will also be interested in clarifying whether startup investment is tax-deductible and in other factors that impact their return on investment (ROI).
A tax professional will take the following into account when determining the tax classification of a SAFE note:
- SAFE Notes Aren’t Considered Debt for Tax Purposes: SAFE notes don’t feature key characteristics like a maturity date or interest accrual. For this reason, SAFE investors don’t usually recognize interest income. The issuing startup also doesn’t deduct any interest expenses.
- SAFE Notes Don’t Give Immediate Equity: A SAFE note doesn’t grant equity in the company at the time of issue. Rather, it represents a right to receive equity when a triggering event occurs. The investor doesn’t become a shareholder when they sign a SAFE, as there’s no immediate transfer of stock or ownership interest.
- Potential Treatment as a Call Option or Forward Contract: Many professionals view SAFE notes as similar to a call option or a variable prepaid forward contract. A call option is an agreement to acquire equity in the future on favorable terms, while a forward contract allows an investor to purchase equity following a triggering event.
These two classifications are significant for the investor in terms of the timing of income recognition and capital gains treatment. If the SAFE is treated like one of these two options, no taxable events occur at its issuance. The investor is only liable to pay tax when the SAFE note converts into equity and is later sold.
Tax and Compliance Considerations for Startup Founders
SAFE notes involve important tax responsibilities, especially around the time of conversion. Failing to handle these issues correctly may result in compliance issues, cap table disputes, and the breakdown of trust with early investors.
Key compliance and reporting issues startup founders should understand include the following:
Founders Generally Aren’t Required to Issue 1099s or Tax Forms
Founders don’t usually need to issue Form 1099 or any other tax forms to their investors when a SAFE note is issued or remains outstanding. In fact, there are no immediate tax consequences for the startup or the investor when a SAFE is issued. This is because SAFE notes don’t pay dividends or interest, so no income needs to be reported.
Remember, SAFE note holders don’t become shareholders until their notes are converted, so no equity-based tax forms are required. Furthermore, the responsibility to report gains or losses falls to the investors who sell converted SAFE notes, not the startup owners.
SAFE Conversions Trigger Reporting Requirements for the Founders
Conversions trigger several administrative and legal obligations for startup companies, even if the conversion itself isn’t a taxable event. These obligations may include:
- Issuing stock certificates or recording digital shares
- Updating your cap table to include new equity holders
- Reassessing your 409A valuation, as conversions may change your startup’s fair market value. Section 409A sets out rules for private companies that issue equity and ensure that the strike price isn’t below fair market value (page 3 of the PDF).
What Are the Risks of Mishandling SAFE Conversions?
Incorrectly classifying SAFE conversions risks landing your startup in trouble. Get help from an expert CPA to avoid common pitfalls like the following:
Reporting and Compliance Problems
Misclassifying SAFE notes as equity or debt will likely lead to incorrect financial reporting. This exposes your startup to IRS audits.
409A Valuation Risks
Converting SAFE notes increases your company’s value. Issuing stock options based on an outdated 409A valuation could lead to IRS penalties. Always plan for a new valuation after significant SAFE conversions and the following funding rounds.
Top Tip: Keep your legal counsel and CPA in the loop during every SAFE conversion. This ensures you stay compliant and avoid triggering unwanted regulatory or tax consequences.
When to Consider SAFE Notes as a Startup Founder
SAFE notes are just one of many ways for startup founders to raise money for their budding enterprises. Founders find SAFE notes particularly effective in the following situations:
- When Simplicity Is a Priority: SAFE notes offer a relatively straightforward way to raise funds for startups. Their lack of rigid terms and conditions streamlines the fundraising process when compared to other, more complex fundraising initiatives like convertible notes.
- When Valuing Your Startup Is Complex: SAFE notes offer a way to raise funds even during your startup’s early days, when a fair valuation is difficult to determine. Issuing SAFE notes allows you to defer this valuation until a later funding round.
Benefits of SAFE Notes for Investors
Understanding the key benefits of SAFEs for investors is critical for founders to secure early-stage investment. These are some of the top tax benefits:
1. Qualified Small Business Stock
Investors who hold qualified small business stock may be eligible to deduct up to 100% of capital gains when they eventually sell. Be aware that SAFE notes themselves don’t qualify as QSBS. The investor’s holding period is key here; they must hold their QSBS for five years to qualify for QSBS exclusion. However, the clock starts when the SAFE converts into preferred stock, not when the SAFE is issued.
2. Early Access to High-Growth Startups
SAFEs allow investors to get in before company valuations rise. This will translate into a significant upside if the startup experiences rapid growth.
3. Valuation Cap and Discount Incentives
The valuation cap and discount rate both protect the investor and offer them favorable terms when the SAFE converts. For example, the discount rate offers a percentage discount on the share price on conversion. This results in the investor getting more equity for their investment.
These benefits plus pro rata rights also go some way to protecting investor ownership from dilution. Anti-dilution clauses go even further to protect early investors’ investments.
Obtain the Maximum Benefit From SAFE Notes
SAFE notes offer startup founders a flexible way to raise early-stage capital, but their federal income tax treatment is far from simple. Understanding how the IRS views SAFE notes is a must to remain compliant and avoid penalties.
With the right guidance, SAFEs are a compelling way to kickstart fundraising success for many startups. Founders should consult tax and legal professionals early and often to ensure they use SAFE notes to their greatest advantage.
