| || |
Recession or not, we have resources to help your business master this moment of high interest rates, labor shortages, sticky inflation, and slower growth. We've put together our Agility & Excellence Resource Center to bring you strategies and solutions with a finger on the pulse of what's ahead.
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.
In this article, we will discuss how SAFEs work, their benefits and drawbacks, and most importantly, their tax implications.
How Does a SAFE Typically Work?
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.
What Are the Benefits of Using a 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.
What Are the Drawbacks of Using a SAFE?
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.
How are SAFEs treated for federal income tax purposes?
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.
Overall, SAFEs can be a good option for startup companies and mature companies that are looking to raise capital from investors. However, investors should carefully consider the terms of the SAFE before entering into an agreement. Given the brief history of SAFEs, and the lack of definitive guidance, proper tax and investment advice is critical for both SAFE issuers and investors.
To learn more, connect with one of our professionals.
Copyright © 2023, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.
CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly traded and privately held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).