Succeeding in Your Business: When SAFEs aren’t so safe, Part 2 of 2

By Cliff Ennico

A simple agreement for future equity, or SAFE, is a contract between a company and an investor under which the investor puts money into the company in exchange for a promise to issue shares in the future upon the occurrence of a triggering event (usually the company’s first round of venture capital financing).{mprestriction ids="1,3"}

Like preferred stock or convertible debt, a SAFE enables investors to participate in a company’s growth (if it succeeds) and get their money out before other investors (if it fails). But unlike preferred stock or convertible debt, a SAFE avoids the need to value the company when the SAFE is issued. SAFEs are increasingly popular tools in both angel investor rounds and equity crowdfundings.

There are two types of SAFE: the pre-money SAFE, in which the number of shares the investor gets upon a triggering event is determined right before the triggering event occurs; and the post-money SAFE, in which the number of shares is determined immediately after the triggering event occurs.

So, how are SAFEs treated for accounting or tax purposes? Are they “debt”? Are they “equity”? Or are they something else in between?

Since with SAFEs it isn’t possible to calculate the exact number of shares (or percentage of the company) an investor will receive when the SAFE is issued, the answer is somewhat complicated.

For tax purposes, a SAFE is not considered debt because of the following:

• There is no fixed maturity date.

• There is no payment schedule.

• There is no interest.

Whether a SAFE is considered equity is more complicated.

There is a general consensus that a pre-money SAFE will be treated as a variable prepaid forward contract (VPFC) or derivative contract for tax purposes, since the buyer pays the seller the purchase price at the time the contract is entered into rather than on the date of delivery of the property, and a variable amount of property is transferred at closing of the contract. With a VPFC, neither the issuing company nor the investor recognizes taxable income when the SAFE is issued.

The more likely it is when the SAFE is issued that the SAFE will convert into shares of stock, the likelier the IRS will treat the SAFE as equity. For example, if the SAFE is issued at a time when equity financing (and, therefore, conversion) is substantially certain to occur very soon after its issuance, the issuance of the SAFE more strongly resembles the receipt of equity rather than a derivative.

A post-money SAFE is more likely than a pre-money SAFE to be treated as equity for tax purposes because of the following:

• Holders have rights to receive dividend payments when a cash dividend is paid on outstanding shares of common stock before the triggering event occurs.

• If the company fails or is acquired by another company, the SAFE holder’s right to receive its cash-out amount is junior to the payment of any outstanding indebtedness or creditor claims; on par with payments for other SAFEs and/or preferred stock; and senior to payments for common stock.

This means the holder will be taxed on the difference between what he or she initially invested and the value of the stock received in exchange for the SAFE when the triggering event occurs.

So, should you invest in a SAFE rather than preferred stock? The answer, as so often, is it depends on the fine print in the SAFE document.

If you think the company is planning just a single round of SAFE financing before seeking traditional venture capital investments, a pre-money SAFE is probably OK. Neither you nor the company will pay taxes until the triggering event (the venture capital round) occurs, and the company will probably appreciate the fact that it doesn’t have to do a formal valuation, which can be very costly and time-consuming.

Just be sure the contract is crystal clear about where you will stand if the company fails or is acquired by another company. Ideally, you should be in the same place as a preferred stockholder: You get paid after all debt is paid but before the common stockholders.

If you think the company is going to launch multiple SAFE financing rounds before seeking traditional venture capital investment, insist on a post-money SAFE. You won’t be diluted by future SAFE investors, and there’s a good chance the stock you receive when the triggering event occurs will qualify for special treatment when you sell it (under Section 1202 of the Internal Revenue Code, the first $5 million of gain from qualified small-business stock is exempt from tax).

If you are an entrepreneur, should you consider one or more SAFE rounds before seeking traditional venture capital investors? Again, it depends.

Yes, if you are extremely disciplined and you know exactly how your ownership of the company will be diluted after each SAFE round takes place.

No, if you are in just about any other situation.

For an excellent article on the pitfalls of SAFEs, see Pascal Levensohn and Andrew Krowne’s article “Why SAFE Notes Are Not Safe for Entrepreneurs.”

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series “Money Hunt.” 

COPYRIGHT 2019 CLIFFORD R. ENNICO
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