The startup accelerator Y Combinator launched the first SAFE, or Simple Agreement for Future Equity, in 2013. Since then, this investment instrument has ballooned in popularity among investors in early-stage companies. Part of the SAFE’s appeal lies in its simplicity. One of the reasons YC launched the SAFE in the first place was to provide a streamlined alternative to the convertible note, previously the norm in startup equity financing. Whereas the SAFE is indeed simpler than the convertible note in many respects, “simple” is not how we’d describe the tax treatment of SAFEs.
Founders typically don’t spend much time fretting about the correct tax treatment of SAFEs, but this may be unwise. How a SAFE is taxed can significantly affect what an investor stands to gain, if and when they receive the shares of company stock underlying the SAFE. Though a SAFE makes negotiations between founder and investor easier, it doesn’t eliminate a founder’s need to understand the investor’s perspective — and tax consequences are certainly a part of that perspective.
In this guide, we’ll review the tax treatment of different types of SAFEs and how it can affect both founders and investors. The IRS characterizes most SAFEs as either equity or as an equity derivative known as a variable prepaid forward contract, but the logic behind this characterization is not always clear-cut. Let’s take a look at the different potential treatments of a SAFE and what they can mean for your next financing round.
- What is a SAFE and how does it work?
- Key terms for understanding how SAFEs are taxed
- How is a SAFE taxed?
- 3 questions that affect how a SAFE is treated for tax purposes
- Why is SAFE tax characterization important?
- Seamlessly manage your equity agreements with Pulley
What is a SAFE and how does it work?
A SAFE (Simple Agreements for Future Equity) is a type of financial instrument often used by startup companies to raise money from investors. As the name implies, it’s a simple agreement between the startup and the investor.
In this agreement, the investor gives the startup money now in exchange for the issuance of company stock at a future date. This future date typically coincides with a triggering event, such as the company’s next equity financing round. When this triggering event occurs, the investor is granted a number of shares of company stock.
Exactly how much stock depends on the terms of the agreement. For example, a SAFE may include a valuation cap that places an upper limit on the per-share price at the time of conversion. A SAFE may also include a discount rate that gives the investor a discount on the price paid by other investors when the SAFE converts into company shares. So, if an investor puts $1 million into a company with a 25% discount rate, their $1 million would convert at a price that’s 25% lower than the price other investors might be entitled to.
Before we get into how SAFEs are characterized for tax purposes, let’s review a few more concepts related to SAFEs and taxes.
Key terms for understanding how SAFEs are taxed
1. Pre-money SAFE vs. post-money SAFE
In a pre-money SAFE, the conversion price for each share is determined by a pre-money valuation of the company capitalization. In a post-money SAFE, the conversion price for each share is determined by a post-money valuation that includes all the shares issued when all the SAFEs are converted.
Y Combinator released the pre-money SAFE first in 2013, then followed up with the post-money SAFE in 2018. The latter is now more commonly used because it gives investors more insight into how much ownership of the company they’re purchasing.
From a tax perspective, this distinction may matter a great deal. A post-money SAFE is more likely to be characterized as equity than a pre-money SAFE, which is more likely to be characterized as a variable prepaid forward contract.
2. Equity vs. debt
Equity is a unit of ownership in a company, such as a share of company stock, which may come with certain ownership rights and privileges. Debt is money that an investor/lender expects to be paid back, and most debt instruments come with an interest rate and a fixed term.
Because a SAFE doesn’t have terms typical of a debt instrument and instead represents a deal to issue equity to the investor at a future date, it is typically treated as equity (or an equity derivative) for tax purposes.
3. Equity vs. equity derivative
This is a crucial distinction when considering the tax treatment of SAFEs. Depending on the type of SAFE (pre-money vs. post-money) and some of the factors related to the SAFE’s issuance, a SAFE will usually be treated as either an equity or an equity derivative for tax purposes.
A derivative is a type of financial contract. It’s called a derivative because it derives its value from an underlying asset. If a SAFE is treated as an equity derivative for tax purposes, that means it is treated as a contract for shares of stock — not as a grant of actual shares of stock.
This distinction matters when it comes to certain tax issues, such as capital gains and tax exemptions. If a SAFE is taxed as equity, then the investor’s holding period would begin on the date the investor bought the SAFE. If it’s taxed as an equity derivative, the holding period begins only after the SAFE converts into stock. More on that in a bit.
4. Triggering event vs. liquidity event
SAFEs are generally considered taxable at the time of the triggering event, when the SAFE converts into equity (i.e. stock in the company). For a post-money SAFE, the triggering event typically means that the investor will receive a predetermined ownership stake in the company — 10% or 20%, for example. An investor with a pre-money SAFE will also receive a certain amount of equity, though the specific ownership percentage they end up with may vary.
A SAFE’s triggering event is usually the next funding round, but this isn't always the case. In some cases, a triggering event might also occur if the company is sold, acquired, or experiences some other type of liquidity event. In general, early-stage investors experiencing a triggering event in the form of an IPO or acquisition is rare, because the company is still young and will most likely need to continue raising money in subsequent funding rounds.
5. Tax compliance vs. tax liability
So far, we’ve mainly discussed the SAFE investor’s tax liability — what they must pay in taxes on the gains they make from investing in a SAFE and, ultimately, receiving equity. But it’s not just the investor’s job to comply with tax reporting requirements. Companies that issue SAFEs are also responsible for reporting details of each transaction (and the resulting tax liability) to relevant tax authorities such as the IRS.
Neglecting tax compliance can lead to issues and potential penalties that make it more difficult for your business to grow, which is why it’s important for founders to understand the tax implications of SAFEs, too.
How is a SAFE taxed?
Because they aren’t debt instruments and don’t have many of the tell-tale features you’d associate with debt (a maturity date, interest rate, repayment terms, etc.), SAFEs are generally not treated as debt for tax purposes.
Post-money SAFEs are typically taxed as equity, while pre-money SAFEs are more likely to be taxed as a type of equity derivative known as a variable prepaid forward contract. Let’s explore why.
When a SAFE is treated as equity for tax purposes
The IRS usually treats a post-money SAFE as equity from the date of the grant. This is consistent with what Y Combinator puts in the actual text of its SAFE financing documents, which include a clause specifying that “for United States federal and state income tax purposes this SAFE is, and at all times has been, intended to be characterized as stock, and more particularly as common stock.”
Post-money SAFEs tend to be treated as equity because they have a lot of equity-like features. For example:
- A post-money SAFE holder has certain rights typical of an equity holder. These include the right to a dividend payment if the company pays a dividend on outstanding shares of common stock (extremely rare at a high-growth startup, but still a right).
- A post-money SAFE is intended to operate like standard non-participating preferred stock in the case of a liquidation event. This means the investor has the right to receive a cash-out amount that is, according to language in the SAFE form, “on par” with payments for preferred stock and “senior to payments for common stock.”
Holding a post-money SAFE isn’t exactly like holding equity; for example, post-money SAFEs typically don’t come with voting rights, which do come with certain types of stock.
There are several other factors that may affect tax characterization as well, and while Y Combinator’s boilerplate language treats this type of SAFE as equity, that doesn’t mean the IRS must follow suit in every case. But it seems fairly safe to say that post-money SAFEs are, in most cases, taxed as equity.
When a SAFE is treated as an equity derivative for tax purposes
There is a specific type of equity derivative known as a variable prepaid forward contract. In a prepaid forward contract, the buyer (i.e. the investor) offers money upfront to the seller (i.e. the startup) for property at a future date. A prepaid forward contract is considered variable when the property in question is not fixed or predetermined.
This is often the case with pre-money SAFEs, in which the number of shares owed to the investor may vary based on the company’s valuation at the time of the triggering event. It wouldn’t make a lot of sense to treat a pre-money SAFE as equity in this case, because you can’t point to a specific number of shares of stock and say, “Ah, this SAFE equals that much.”
A SAFE that’s characterized as a variable prepaid forward contract is essentially considered an open transaction, rather than a closed deal for equity. Only when the transaction is closed and the equity has changed hands is the transaction considered closed. This moment — when the investor receives the stock — is also considered the taxable event, at which time the investor’s holding period for the stock begins.
3 questions that affect how a SAFE is treated for tax purposes
So, in most cases, a SAFE should be treated as either equity or an equity derivative for tax purposes. But not every case is cut-and-dry, and it helps to understand the specific aspects of a SAFE that affect its tax characterization. With that in mind, here are three questions to help clarify why SAFEs are taxed the way they are:
1. Does the SAFE look or act like a debt instrument?
The simple answer is “No.” A SAFE does not represent a debt to the investor, but rather a promise to the investor to issue equity at a future date. Furthermore, SAFEs do not come with an interest rate and a maturity date at which the investor/lender is entitled to full repayment. As such, a SAFE should generally not be treated as a debt instrument for tax purposes.
2. Is the SAFE highly likely to convert into shares of stock?
Tax authorities may be more likely to consider a SAFE equity if it is highly likely to convert into shares of stock. For example, a SAFE that closes just prior to an expected equity round is probably very likely to convert into shares of equity, so the IRS may be more inclined to characterize it as equity from the get-go.
3. Is the SAFE investor entitled to dividend or voting rights?
Stock generally comes with certain rights. Whether a SAFE also has these rights may be a factor in determining whether the SAFE should be treated as stock. We already covered some of these rights above, and determined that a typical SAFE may include some rights (dividend rights) and not others (voting rights).
Different SAFEs may have different terms, however, and it’s technically possible that a SAFE holder also has some kind of voting power with regard to the company’s management and governance. If this is the case, it is even more likely that the SAFE will be considered equity for the purpose of taxation.
Why is SAFE tax characterization important?
If a SAFE is characterized as equity from the date the deal closes, the investor holds an ownership stake in the company from that date (at least as far as tax authorities are concerned). If it is characterized as an equity derivative, the investor’s holding period in the underlying stock begins only at the time of the triggering event.
The length of an investor’s holding period in stock can matter a great deal for that investor’s returns. If a SAFE is considered equity from the date it’s purchased, then the investor will be able to qualify for more favorable long-term capital gains rates earlier. (These rates kick in one year from the date the stock is purchased.)
Investors who want their stock to qualify for the qualified small business stock (QSBS) tax exclusion also benefit from an earlier start date to their holding period. Under this exclusion, certain small-business stocks can qualify for up to a 100% exclusion of tax on capital gains. But to claim it, you must satisfy a five-year holding period, among other criteria. Starting that five-year period earlier can result in a major tax boon for investors in some cases.
So, this isn’t all just a vulgar display of pedantry. The tax treatment of SAFEs can really matter for investors’ outcomes. Which is why smart investors factor this in when negotiating their SAFEs.
Seamlessly manage your equity agreements with Pulley
Though the SAFE is considered to be among the simplest and most transparent investment instruments out there, it’s not always so cut-and-dry. This is especially true when it comes to how SAFEs are taxed. Y Combinator has foreseen this, which is why their financing documents and templates explicitly address the SAFE taxation question. But the IRS doesn’t need to abide by that contractual language, so it pays to understand the individual cases in which a SAFE may not be treated as equity for taxation purposes.
As a founder, this may still sound a bit confusing to you. We get it. We built Pulley with founders in mind, and we’ve outfitted our product with a ton of tools to help you stay on top of your equity:
- Our cap management tool makes it easy to track and manage SAFEs along with all the other types of equity on your cap table.
- Our fundraising modeling gives you insight into how a SAFE may impact your share dilution in current and future equity rounds.
- We even have tools specific to crypto and web3 startups, in case you’re planning to work with SAFE-related investments such as the Simple Agreement for Future Tokens (SAFT).
