SAFE notes (Simple Agreement for Future Equity) were started by Y Combinator in 2013 and have been heavily utilized over the past decade among startups. This form of financing was initially used by C corporations, but over the past several years, SAFEs in LLCs and partnerships have rapidly increased in popularity. This begs the question, “can S corps issue SAFE notes?”

What is a SAFE Note?

• Simplicity and Cost Effectiveness: SAFE notes are simpler and more straightforward compared to traditional equity or debt financing instruments like convertible notes. They require less legal paperwork and incur lower transaction costs, making them an attractive option for startups that want to minimize administrative burdens.
• No Interest or Maturity Date: Unlike convertible notes, SAFE notes do not accrue interest and do not have a maturity date. This absence of debt-like features removes the pressure of having to repay the principal or manage interest payments, thus reducing financial strain on the startup.
• Flexibility in Valuation: Since SAFE notes convert into equity at a future financing event, founders can delay setting a valuation for the company until they have a clearer picture of its worth. This can be particularly beneficial if the startup is in a sector where early valuations are difficult to ascertain or if the company anticipates significant growth in its early years.
• Maintaining Control: SAFE notes typically convert into equity during a significant future financing round, allowing founders to maintain greater control over the equity distribution and cap table management until they are in a stronger negotiating position. This control can be crucial in the early stages when preserving founder equity is important.
• Attractiveness to Investors: For investors, the simplicity and potential high returns of SAFE notes make them an attractive investment vehicle. This can widen the pool of potential investors for a startup, including those who may be looking for less complex ways to participate in startup financing. Investors also receive a discount on their investment at the next round of funding.
• Avoids Immediate Dilution: Since SAFE notes convert into equity at a later date, founders avoid immediate dilution of their ownership stake. The dilution that eventually occurs can be better managed as part of a larger financing round, typically at a higher company valuation.

Tax Treatment of SAFE Notes

So, Can S Corps Issue SAFE Notes?

1.  As mentioned above, the most common tax treatment of SAFE notes is equity. It is assumed the IRS shares the same view. If this is the case, a SAFE note would be a second class of stock.
2. More and more SAFE notes include language of investors getting paid back first. Actual or implied liquidation preference violates the one class of stock requirement. With an S corp, shareholders have the same preference in the event of liquidation.