In 2013 a new investment scheme was introduced to the world by Y Combinator, a well-established start-up companies accelerator. A Simple Agreement for Future Equity ("S.A.F.E.") allows a company to receive funds in exchange for an obligation to issue shares in the future, if and when a fundraising round, a liquidity event, or an I.P.O. occurs. Due to its the relatively simple nature for capital-raising, the S.A.F.E. became very popular among start-up tech companies.

The S.A.F.E. does not properly fit into any of the usual categories of investment vehicles, such as debt or equity, and there is much ambiguity as to the proper characterization of A S.A.F.E. for U.S. tax purposes.

Earlier this year, the Israeli Tax Authority ("I.T.A.") published its position on taxing a S.A.F.E. The I.T.A.'s position is not the main focus of this article, but it evoked the interesting question of how should a S.A.F.E. be characterized for U.S. Federal income tax purposes. Interestingly enough, the I.R.S. has not yet published any guidance on point.


A S.A.F.E. typically refers to a financing arrangement under which an investor tenders an agreed amount to a company, in exchange for the company's obligation to issue stock (typically preferred stock) at a later time. At the signing of the S.A.F.E., the specific date on which shares will be issued and the price per share at time of issuance are unknown. Instead, the parties typically agree on the following mechanic

  • Shares will be issued upon a future financing round, a change in control, an initial public offering, or a dissolution (a "Triggering Event").
  • The price-per-share will be determined based on the company's valuation on the Triggering Event date, subject to a valuation cap or a specified discount.

If the parties agree on a valuation cap, the stock value at the time of conversion is limited to a maximum amount.1 This mechanism protects the investor's rights by ensuring that the investor's price per share does not rise too high causing the number of shares issued to fall below an acceptable amount. The alternative mechanism designed to protect the investor's rights is granting the investor a pre-determined discount for the future shares.2 The discount alternative imposes no limitation on the investor's future price per share, but it ensures that such a price will be a better price relative to the price in the next financing round. 

The S.A.F.E. is relatively straightforward to create and implement. The parties do not need to evaluate the company's stock, negotiate interest payments, or subject the agreement to certain conditions or restrictions that typically apply to debt instruments. This presents a significant benefit to the company because it is able to raise additional funds quickly and easily in the future. The investor derives its own advantages, mainly the opportunity to benefit from an upside of the company's shares after the time the S.A.F.E. is signed.

Nonetheless, a S.A.F.E. presents its own set of disadvantages, as well. The Triggering Event might never occur, and the investor might lose the entire investment. Repayment rights typically kick in only upon the company's dissolution and, in any event, they are junior to the rights of creditors. The S.A.F.E. investor might also incur losses if a Triggering Event occurs, but the company's valuation is lower than was expected at the time of funding the S.A.F.E. These are typical risks of equity owners.

Another significant disadvantage is the lack of clear taxing rules, thereby creating a level of uncertainty for both parties to the S.A.F.E. arrangement. In the absence of specific taxation rules, a common approach to quantifying expected tax consequences is to equate a new instrument such as the S.A.F.E. to a type of instrument that it resembles most, and for which established taxing rules exist.

This raises the main question that remains unanswered, except perhaps, to a limited extent, in Israel. In what category does the S.A.F.E. fit? The possible alternatives include debt, stock, warrants and forward contracts. Below is a short discussion on each of these alternatives.


There is a large body of case law identifying several key factors that point to the status of an instrument as debt, rather than equity, based on common law principles.3 Those factors include, inter alia,

  • the borrower's repayment obligations, typically with a schedule of payments;
  • a fixed maturity date;4
  • stated interest payments;
  • the borrower's preferred rights on dissolution
  • credit worthiness of the borrower, measured for example based on the debt-equity ratio;
  • no rights of conversion into equity are granted to the borrower;
  • documentation and the title of the instrument refer to a debt instrument; and
  • the parties' intent to treat the instrument as debt.

The weight given to any factor varies from case to case, indicating that the answer depends on all the facts and circumstances that are present.5

The S.A.F.E. does not meet the above factors and therefore lacks the essential indicia of a debt. The company is not obligated to repay the S.A.F.E. amount and there is no maturity date. There is also no obligation to pay any interest. The S.A.F.E. holder's rights are usually junior to those of any creditor and the legal documents typically clarify that the parties did not intend to create a debt instrument. Therefore, the common view is that a S.A.F.E. should not be treated as a debt instrument for tax purposes.6

Convertible loan agreements ("C.L.E.s") are debt instruments that give the holder the right to convert the debt instrument into an equity security. Despite their hybrid nature, they are typically treated as debt for U.S. tax purposes until converted to stock.7 It follows that, since a S.A.F.E. should not be treated as debt, a S.A.F.E. should not be treated as a C.L.E. In fact, the S.A.F.E. was originally designed by Y Combinator to avoid having C.L.E. characteristics.8

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1. To illustrate, the investor invests $200,000 in a company under the S.A.F.E. and the parties agree that the value of the company will be capped at $2 million. This means that the investor will receive 10% of the company's stock at the time of a Triggering Event, even if the Triggering Event takes place when the company is evaluated at $4 million. Without the cap on value for conversion purposes, the investor would have received shares reflecting 5% of the company.

2. For example, if the parties agree on a 20% discount and the price per share at the closing of the Triggering Event is $10, the price per share offered to the S.A.F.E. investor is only $8. As a result, a S.A.F.E. investor who invested $200,000, and should have received 20,000 shares based on a price of $10, will receive 25,000 shares (200,000 ÷ 8 = 25,000).

3. See, for example, Indmar Products Co. v. Commr., 444 F.3d 771, (6th Cir. 2006); Roth Steel Tube Co. v. Commissioner, 800 F.2d 625 (6th Cir. 1986), affg. T.C. Memo 1985-58; Estate of Mixon v. U.S., 464 F.2d 394 (5th Cir. 1972)); Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968); and Laidlaw Transp., Inc. v. Commr., T.C. Memo 1998-232.

4. See Farley Realty Corp v. Commr., 279 F.2d 70 (2nd Cir. 1960): "Numerous cases have held that the absence of a fixed maturity date is a crucial factor weighing against a corporate taxpayer's claim that a debtor-creditor relationship existed between it and its payee." Laidlaw Transp., Inc. v. Commr., supra, (citing Estate of Mixon v. U.S., supra).

5. John Kelley Co. v. Commr., 326 U.S. 521 (1946); Notice 94-47, 1994-1 C.B. 357.

6. See, e.g., Damsky, Pigeonholing the 'S.A.F.E.' and 'KISS,' Tax Notes, May 7, 2018, p. 831; L.P. Adamo, Tax Treatment of S.A.F.E.s, Lowenstein Sandler Client Alert..

7. See, for example P.L.R. 201517003, cross-refencing to H.R. Rep. No. 105- 220, at 524 (1997): "This appears to indicate a Congressional preference for treating convertible debt instruments as valid debt in most cases." However, where it is substantially certain that the holder will receive stock, the instrument is presumed to be equity and interest deduction will not be allowed. See also Code §163(l). The conversion of the debt into equity is also not a taxable event because it is a mere exercise of rights embedded in the security under its own terms. Treas. Reg. §§1.1272-1(e) and, 1.1275-4(a)(4).

8. See here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.