For any security to qualify under Section 1202 as Qualified Small Business Stock, the company must first be considered an eligible Qualified Small Business (QSB) meaning:
- It is a domestic C-Corp
- It has less than $50 million in gross assets (when the stock is issued)
- It is an active business in a qualified trade
- Learn more about about the additional requirements to be a Qualified Small Business
The securities themselves must also satisfy certain criteria including:
- They were acquired at original issuance
- They were acquired in exchange for money, other property (not including stock), or as compensation for services provided to such corporation
- They were held for a minimum of five years
For each security type however, when the 5-year holding period begins is determined based on nuances particular to each security type. Depending on the security type the holding period might begin on the purchase date, the exercised date, vesting date, etc.
What are “SAFE Notes”?
Simple Agreements for Future Equity, otherwise known as SAFEs, exist thanks to the startup accelerator Y-Combinator’s 2013 innovation.
With a SAFE, an investor makes a cash investment in a company, but the actual amount of stock they receive is determined at a later date, in connection with a specific event, typically the next priced financing round. A SAFE is not a debt security, but was created as an alternative to convertible notes, which are issued in initial funding for early stage startups.
SAFE notes are similar to convertible notes in the fact that it allows founders to raise money without putting a price tag (valuation) on their company and preferred stock issued to investors. However, unlike convertible notes, SAFE notes are not considered convertible debt. SAFE notes are simple agreements for future equity with no interest or future payment obligations. SAFE notes will convert either at the discretionary of the investor or at the next priced round, depending on the conversion clause in the SAFE note agreement.
The Four Types of SAFE Notes
Just like convertible notes, SAFE notes will convert at either (a) a discount, or (b) a cap. It depends on the pre-money valuation of the subsequent priced round. The cap is intended to protect the investor from being diluted in a subsequent high valued round and the discount is intended to make up for the risk of the investment. The four types of SAFE note are:
- Cap, no discount
- Discount, no cap
- Cap and Discount
- MFN, no cap, no discount
What are the Positive Traits of SAFE Notes?
A SAFE Note provides an element of simplicity that convertible notes lack, although convertible notes are fair in the issuance process as well. A lawyer may not even be necessary for the creation of the 5-page document required for a SAFE (however legal counsel is recommended). No end date and zero interest makes this security type straightforward for businesses and investors. Little negotiation goes into the draft with the exception of the valuation caps.
Provisions that protect both the company and investor included in the SAFE Notes are: early exits, change of control, and dissolution. At any future date (not predetermined by the SAFE) when preferred shares are distributed, an investor can convert their investment into equity in the company.
This looseness of terms and conversion dates provides beneficial flexibility for startups who can often be limited by investor expectations.
What are the Negative Traits of SAFE Notes?
SAFE Notes run the risk of never converting into equity as they are not considered an official debt security like Convertible Notes.
Startups that are still organized as LLCs and have not yet incorporated are not eligible to issue SAFE Notes. Additionally, the lack of minimum requirements can cause issues with legitimacy of fundraising rounds and means the SAFEs can be adjusted without notice.
How are SAFE Notes Taxed?
Investors must consider the holding period that accompanies the purchase of any type of security. The holding period for SAFEs begins when the note is converted into equity, as opposed to convertible notes which have a retroactive holding period once the security converts. The holding period between the conversion and the next round of financing can last up to longer than a year. Some investors turn to financial stability in the long run and will attempt to hold out on their note for 5 years in order to be eligible for the Section 1202 QSBS exclusion.
An investor can lose out—in the case of QSBS—in the event that the company is sold less than a year after the SAFE is purchased or if a non-cash sale occurs. Investors who hold convertible notes are also at risk of this same type of event.
Are SAFEs Safe for QSBS?
The Section 1202 QSB stock capital gain exclusion conditions state that an investor must hold QSBS for at least five years in order to claim exclusion of the disposal gain. According to Section 1202, “eligible gain means any gain from the sale or exchange of qualified business stock held for more than 5 years.”
This leads to a very important question: Does the holding period for SAFEs start upon issuance of the SAFE or once they’re converted into equity?
There is an ongoing debate about the qualification of SAFEs as QSBS and how the time at which the “QSBS clock” starts could end up being the difference between an ultimately tax free capital gain or a substantial tax liability on disposal.
Read more about how the IRS ruled on a related case involving the 5-year holding period.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.