Wading through the uncertainty of simple agreements for future equity

Introduction

Simple Agreements for Future Equity (SAFEs) were introduced by promoters in 2013. These original contracts are now commonly referred to as “pre-money” SAFEs. Revised “post-money” agreements were released in 2018. These agreements are designed to assist startup entities with funding and expertise by raising money as an alternative to convertible debt and to save on legal fees. The agreements are widely available online and are being used, in many cases, without any input from tax or legal advisors, or significant modifications to tailor such agreements to a taxpayer’s particular facts and circumstances.

A major issue facing tax practitioners is the characterization of SAFEs; whether these are taxed as debt, equity, or some other type of instrument. As noted below, some commentators have posited that SAFEs could be a variable prepaid forward contract. Given the broad array of tax consequences (as outlined in the characterization section) determined by how a particular SAFE agreement is characterized, it is important to confer with an advisor when evaluating whether to utilize such a vehicle. However, in our experience, we have seen numerous cases where a tax professional has not been consulted before the parties have entered into the SAFE instrument.

The uncertainty on characterization of SAFEs is due to the hybrid nature of the agreement. It does not fit neatly into being characterized as debt, equity, or some other type of instrument (e.g., a variable prepaid forward contract). The name of the instrument itself does not mention that it is equity, debt, or other type of instrument; resulting in uncertainty as to how these can impact taxable income.

How SAFEs operate

How the SAFE instrument is drafted controls how it functions. A common pattern is where an issuing corporation receives cash from investors in exchange for a promise that same corporation will issue preferred equity in predetermined amounts (often at a discount) in the future (usually upon the occurrence of certain triggering events). During the period that the SAFE is outstanding, it does not pay interest and has no maturity date.

In many cases, if there is a liquidity or dissolution event, the investor will automatically be entitled to some, or all of their money back based on a predetermined formula. In a liquidation event, the post-money SAFEs are intended to operate like nonparticipating preferred stock – the investor receives proceeds after payment of debt and other creditor claims, but before payments to common stockholders and pro rata with other SAFEs and preferred stock. This imposes some risk on the investor if the startup loses money and assets are insufficient to pay creditors. In some post-money SAFEs, the SAFE investors are entitled to be paid dividends on par with those paid to common stockholders. Holders of the SAFE instruments generally do not have voting rights.