Preface: Simple Agreement for Future Equity (SAFE) provides entrepreneurs with an option towards simplified financing on business ventures. While federal taxation can be a puzzle on a SAFE, the hybrid financing method has a place for certain ventures. This blog is to provide funding ideas for ventures to entrepreneurs who want to enjoy a first mile.
Credit: Donald J. Sauder, CPA
In recent years, a hybrid financing structure for start-up businesses has been introduced to the marketplace termed “Simple Agreement for Future Equity” (SAFE). Convertible debt has been used for decades to finance entrepreneurship. The SAFE is created to improve upon convertible debt with common characteristics:
- Conversion provisions for an early exit from the investment
- SAFE’s are not classified as a debt instrument, since they do not have a maturity date, so there is a chance the SAFE never converts to equity or repayment occurs; simplifies rules of startup financing.
- Since it is not a loan, there is no accrued interest
- Simplified documentation of the uniform agreement (if agreed to) saves start-ups and investors legal fees and reduces negotiations of the terms of the investment.
Their are typically only two main negotiation terms for a SAFE , 1) valuation capitalization 2) Discount Rate.
The negatives of a SAFE are that they require incorporation of the investment; and investors assume all the risk since there is no priority decision to convert the debt; then founders typically receive less equity too, i.e. hinged to the negotiation of SAFE terms.
While SAFE tax treatment can be a puzzle of objective determinations and subject to tax court rulings, typically SAFE financing is more an equity investment than debt for federal taxation and highly sensitive to facts and circumstances; individual ruling differ. SAFEs are an ultimate gray area of tax codes.
Why a SAFE is advised
Most large business ideas are fueled with cash. A SAFE provides that cash with less risk to a business founder. SAFE has several advantages. First, a SAFE has no accruing interest rates on the investment, e.g. no cash outflow deadlines to investors while building the business. Secondly, with a SAFE most of the risk is passed to the investors.
Because a SAFE, if conversion occurs to equity, is on pre-negotiated terms in connection to future priced equity rounds, the post-money and pre-money basis are crucial. While a SAFE can be simple, if you’ve a venture capitalist who knows the street, modified terms require a good attorney to walk the path towards equity on the modified terms, before a pending conversion occurs. Spend the time and money to get it right.
SAFE financing has a real place in the business financing marketplace. Before you embark on a SAFE financing your advised to talk with a security attorney, then decide how much equity and control your willing to sell; and lastly, keep it simple.
Like all business financing, you need willing investors, but a well-planned, strategic SAFE can fund your business idea’s; and get them on the runway with a low risk financing.
This blog is for educational purposes only, and not be construed as tax, business, or legal advice. Talk with you accredited advisor before considering any SAFE decisions.