What is a SAFE agreement and what are its tax implications?
Simple investment agreement SAFE simple agreement for future equity.
The primary purpose of a SAFE (Simple Agreement for Future Equity) is to provide investors with a future right to equity in a company while giving the company immediate investment funds. This agreement helps mitigate the main challenge for potential investors in startup companies, which is the valuation gap.
A SAFE resolves this by delaying the valuation assessment until a time when the value can be more concretely established.
Another problem that SAFE agreements address is the lengthy and comprehensive due diligence process often required in traditional funding rounds. The assumption with a SAFE is that future funding rounds conducted by venture capital firms or through public offerings will include a prospectus or detailed due diligence, thereby establishing a more substantiated valuation than what an early-stage investor might be able to assess.
The mechanism of a SAFE
The SAFE (Simple Agreement for Future Equity) mechanism typically sets the valuation according to a future fundraising valuation, providing the investor with a discount on this later valuation. Upon receiving the investment, the company records an obligation to the investor, enhancing the investor’s priority in the order of creditors. This obligation is then converted into shares of the company at a rate that is preferential to the issuance or new fundraising price.
The SAFE agreement is designed to simplify the capital raising process for startup companies more than the more commonly known mechanism—convertible loans.
The exact terms of a SAFE agreement vary, but the basic principle is that the investor commits a certain amount of capital to the company at signing, and in return receives shares in the company, subject to contractual commitments regarding the timing of the allocation at a later date. The events that allow the investor to receive their equity option depend on the agreement and vary from contract to contract. The price per share is not agreed upon at the time of the agreement’s conclusion. Instead, the investors and the company negotiate the terms under which the future shares will be issued.
Tax implications of a SAFE agreement
Can vary depending on the investor’s profile. For example, an investment from a foreign company with special relations with the recipient company could be considered as an interest-bearing loan subject to withholding tax in Israel under various sections of the Income Tax Ordinance and the General Contract Law.
In contrast, if the investor controls the recipient company, the investment might receive tax exemptions on cost adjustments, while the same amount constitutes an expense for the company.
Additionally, the company’s service providers, employees, and other related parties might face different tax consequences from such an investment. In certain cases, the drafting and execution of the agreement require expertise in tax law, particularly in international taxation and transfer pricing. Entrepreneurs are advised to consult with a tax expert in all cases and not to underestimate the initial investments, even if they are not substantial.
The solutions to potential exposures in such agreements can vary, ranging from the way the agreement is drafted, to expert opinions, decisions from the tax authority, or transfer pricing studies. For more detailed guidance on this topic, you can contact us.
