SAFs don`t exactly fit into a cubbyhole. Despite their similarity to convertible bonds, they should not be treated as debts, in particular because of the absence of repayment obligations, interest payments, creditor rights and maturity dates. Traditionally equity rights, such as dividend rights and corporate voting rights, are also lacking, but they can be treated as equity if they are essentially safe to be converted into equity at the time of issuance. SAFS are generally easier to agree and trade than convertible bonds because they do not include maturity dates and interest rate terms. Since they can continue indefinitely, there is no need to define when a conversion to actions is triggered. Y-Combinator has developed SAFEs as quick and simple documents. However, the complexity is likely to occur or be recognized after the SAFE is issued, rather than before or during the exposure of the SAFE. As discussed in this article, one complexity often overlooked by investors (and companies) is the tax treatment of SAFEs. Unless a SAFE is considered advance capital, investors who buy SAFEs instead of equity delay the start of the capital appreciation clock (one year) and the “qualified small business shares” watch (five years) (and could lose as a result of this delay), which could mean that they are giving up substantial tax benefits. Investors and issuers should discuss the tax treatment of receiving a SAFE based on the particular circumstances in which the SAFE was issued.
While it seems clear that a SAFE should not be treated as a debt for tax purposes, it is advantageous for a SAFE holder to understand in advance the treatment of the SAFE for tax purposes, as this can influence the nature of the profit derived from the disposal of the shares underlying the SAFE. A SAFE (Simple Future Equity Agreement) is an agreement between an investor and an entity that grants the investor rights for future capital to the company similar to a warrant, unless, without determining a specific price per share at the time of the initial investment. The SAFE investor receives the futures shares in the event of an evaluated investment cycle or liquidity event. SafThe aim is to offer start-ups a simpler mechanism to seek start-up financing as convertible bonds. The IRS and Finanzgericht consider a number of factors in determining whether an instrument is debt or equity for U.S. federal income tax purposes. If an instrument gives the investor the right to participate in the growth of the business, the instrument can be treated as equity, even if it is called “debt”. For example, the IRS found that convertible bonds are treated as equity when the probability of debt being converted into common stock was very high.8 A SAFE is not investor-friendly and may be the least “safe” investment instrument available to an early-stage investor. . . .