Article

Wading through the uncertainty of simple agreements for future equity

2023 year-end tax letter

Oct. 30, 2023 · Authored by Pat Balthazor, Bruce Feinstein

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.

The characterization of the instrument for tax purposes is important for many reasons. Two of the most significant are:

Holding period

1. Long-term capital gain treatment applies only to capital assets held for more than one year.
2. Section 1202 requires that C corporation stock be held for more than five years to qualify for a full or partial exclusion of gain. This can be extremely important to investors as startup companies may be sold at large gains after a relatively short period of time.

Changes in ownership

1. Section 382 limits the ability of C corporations to use certain tax attributes following a change in ownership exceeding 50% during a testing period.
2. The tax attributes that may be limited include net operating loss carryforwards, tax credits, interest expense carryforwards under section 163(j) and certain built-in losses.
3. Startup corporations often operate at a loss during their early years and the use of these attributes can be vital going forward.

Tax practitioners have analyzed SAFEs over the years and have reached different possible characterizations. These include debt, a warrant or option, a variable prepaid forward contract, or equity. Each of these characterizations has strengths and weaknesses. In addition, the consequences of the characterization vary, particularly with respect to the holding period. While investors may expect to hold their investment for over a year to meet the long-term holding period for capital gains, the five-year holding period for qualification under section 1202 is less certain. If successful, many companies are sold within a relatively short period after formation. At the outset, investors want certainty as to when their holding period starts. The following is a brief discussion of four possible characterizations, with an emphasis placed on when the holding period starts. Except where noted, the conversion of the SAFE to preferred stock would generally be tax-free to both the issuing corporation and the SAFE investor.

Possible characterizations

Debt: Several commentators have said that SAFEs generally should not be treated as debt. Courts have provided many factors to be considered when determining if an instrument is debt. Among the most important factors are a fixed maturity date and interest payments; SAFEs have neither of these attributes. In fact, SAFEs were specifically created to avoid being treated as debt that is convertible into preferred stock. Corporations do not want debt on their balance sheet with interest payments that could potentially be limited under section 163(j). The corporation could also recognize cancellation of debt income when the debt is converted to stock and the value of the stock is less than the amount of the debt.

If the debt is a security, the holding period of the debt may be tacked onto the stock; however, this would not apply for the gain exclusion under section 1202. The holding period under section 1202 begins on the date that stock is actually issued.

Warrant: A SAFE resembles a warrant in some respects, mainly because an investor may receive preferred stock in the future for a payment of cash when the SAFE is acquired. But it differs from a typical warrant for several reasons. A warrant is a contractual arrangement that generally requires the holder to pay an amount for the warrant which then gives the holder the right to acquire a specified number of shares of stock within a specified time period for a specified strike price. SAFEs do not have the characteristics that a warrant typically has:

1. There is no specific time period for issuance of the stock.
2. The entire amount to be paid is remitted when the SAFE is acquired.
3. The amount of shares to be delivered may vary.
4. The property to be acquired (usually preferred stock) does not even exist at the time the SAFE is acquired.
5. The ability to exercise or not does not rest with the investor – it is dependent on the preferred stock capital raise.

The Supreme Court and the IRS have stated their positions that the holding period for property received upon exercising an option or warrant begins when the option or warrant is exercised. This would apply when determining whether a sale is long or short term. It would also apply for determining the start of the holding period under section 1202. Taxpayers attempting to argue that the warrant is a security and the holding period of the SAFE would tack onto the preferred stock holding period may be advancing a position that would be difficult to sustain.

Variable prepaid forward contract: Prior to the modifications made in 2018 (when the post-money changes were made), SAFEs had characteristics that were close to those of a variable prepaid forward contract (VPFC). A VPFC involving stock is a contract between two parties where one party agrees to transfer stock to another party at a fixed date in exchange for an upfront payment of cash. The number of shares can vary based on the stock price at settlement. The IRS, in 2003, ruled that a sale did not occur when the contract was entered into. Instead, the sale occurred when the shares were transferred. An important factor in the ruling was that the seller retained legal title to the shares and was entitled to any dividends paid.

While SAFEs have some of the characteristics of a VPFC, there are also differences. With a SAFE, the property to be exchanged does not even exist at the time that the cash is transferred. There is also no fixed date on which a SAFE investor will receive preferred stock. Even with these differences, a typical SAFE arguably could be a better fit as a VPFC than as debt or a warrant. If the corporation issuing the SAFE includes the provision that allows SAFE investors to receive dividends on par with those paid to common stockholders, the SAFE acquires a stronger equity flavor.

The VPFC characterization has the same issues as warrants related to the tacking of the holding period. Arguing that the start of the holding period for the preferred stock is other than the date that the stock is received may also be difficult to sustain.

Equity: If the post-money SAFE provisions relating to payments on a liquidating event and participation in dividends are included in the SAFE agreement, the equity flavor of the SAFE is further augmented. These provisions improve the argument that the instrument is equity by establishing that the investor has some of the benefits and burdens of equity ownership. This is not a certainty, though. Characterizing an instrument as debt, equity or something else has always been uncertain. As noted above, certain promoters believe the pre- and post-money SAFEs should be treated as equity securities, but they also note that they do not give tax advice and taxpayers should consult with their tax advisor.

Many post-money agreements contain a provision that the parties agree that the SAFE should be treated as common stock for purposes of certain enumerated sections of the Internal Revenue Code and contain covenants of consistency to that effect. While the IRS may argue that a statement such as this does not carry much weight, it is helpful in establishing intent.

Consistent treatment by both parties is important. If equity treatment is appropriate, any distributions received should be reported as made with respect to stock by both the corporation and investor. In addition, if the SAFE is treated as equity, an exchange of the SAFE instrument for preferred stock is a recapitalization and informational statements should be attached to both the corporation’s and the investor’s income tax returns.

Characterization as equity solves the holding period issues. The holding period for the SAFE is tacked onto the holding period for the preferred stock. While SAFE instruments are not generally intended to be outstanding for long periods of time before being converted to preferred stock, one can never be sure. If the SAFE is deemed to be equity, at least the investor knows when the clock starts ticking on the holding period.

Conclusion

Characterization of SAFEs are likely to retain their current level of uncertainty. The IRS has not issued guidance on these agreements and is unlikely to do so in the near future. This leaves the corporate issuer and investor with some risk that the IRS may characterize a SAFE inconsistently between various issuers and their investors. Practitioners representing different SAFE investors may even take inconsistent positions on the same issuance. Ways to minimize uncertainty include the following:

1. Draft the agreements to acquire stock to agree with the desired characterization. If equity treatment is wanted at the outset, avoid the SAFE and issue preferred stock. This can be made convertible into another type of preferred stock if necessary. Unless taxpayers are dealing with a SAFE promoter as an investor, there is no requirement that a SAFE be used.
2. If using a SAFE, draft the agreement so that it has as many characteristics as possible to secure the desired treatment. For example, if the agreement is to be characterized as equity, include as many provisions as possible to make it look like equity. Consider dividend, liquidation and voting rights when drafting the agreement.
3. Be consistent in the treatment. If the corporation makes distributions and the SAFE is deemed to be equity, investors should treat the distribution as a dividend if the corporation has earnings and profits. Informational statements, such as recapitalization statements or 1099s for interest or dividends should be issued in accordance with the desired treatment.

Taxpayers that use SAFEs may be taking on some risk that the IRS will characterize the instrument in a way that is not favorable. Consider whether the simplicity and possible upfront savings in legal fees is worth the risk. In all cases, to be prudent, we recommend that you consult with a tax professional before making the SAFE investment. Using a SAFE with an S corporation should be avoided as it may create a second class of stock which would terminate the S election.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.