On May 16, 2023, the Israeli Tax Authority issued guidance regarding the taxation of investments in companies through Simple Agreement for Future Equity (i.e., SAFE).
SAFE instrument was introduced as an alternative to traditional investment or convertible loan for early-stage investments in startups. SAFEs offer simplicity, efficiency and cost-effectiveness and enable the startup companies to raise funds quickly while maintaining the valuation question for a later stage.In SAFE, the investor transfers funds to the Company upon execution of the SAFE with the conversion of the funds to the company’s shares at a later stage upon the occurrence of certain events (generally, qualified equity financing; non-qualified equity financing; dissolution or M&A/exit event).
When investors convert their investment into shares, they gain a significant advantage by receiving a greater number of shares due to a predetermined discount on the share price or having their investment converted into shares based on a predetermined maximum valuation of the company.
Until recently, it was unclear whether this advantage is considered an interest income, resulting in a taxable event for the investor, or rather the entire transaction is seen as a unified investment with no tax event.
The guidance sets a “safe harbor” under which conversion of the investment amount, which has been invested through those SAFEs that satisfy the safe harbor requirements, to the company’s shares will be deemed investment in equity of the company for tax purposes. Accordingly, conversion of those SAFEs that satisfy the safe harbor requirements, would not trigger a tax event for the investor. The guidance aims to provide clarity and guidance for stakeholders navigating the tax landscape in relation to SAFE investments.
To qualify for the safe harbor, the following requirements should be satisfied.
First, with respect to the company which issues the SAFE:
(a) Issuing Company: The investment is in an Israeli resident company engaging in high-tech business.
(b) Company’s R&D Expenses: During the earlier of (i) three years prior to execution of the SAFE in which the company has audited financial statement and (ii) the period between incorporation of the company and its execution of the SAFE, most of the company’s expenses are classified as R&D expenses or development or marketing of products developed by the company in connection with such R&D activity. In addition, the company’s R&D activity exists as of the date of execution of the SAFE.
(c) Company’s Value: The majority of the value of the company’s assets are not deriving, directly or indirectly, from real estate located in Israel.
(d) Previous Fix Price Funding: The company has not raised equity funds with a fixed share price within the period which is three months prior to the closing of the SAFE.
Second, with respect to the terms of the SAFE:
(a) Maximum Investment Amount per Investor: The maximum amount invested per investor, directly or indirectly, does not exceed NIS 40 million.
(b) Investor’s Assignment Right: The investor’s right to assign its rights under the SAFE prior to conversion of the SAFE (other than to its permitted transferee as defined in the SAFE) is subject to the company’s approval.
(c) Title/References within the SAFE Agreement: The SAFE is not called as, or refer to as, a loan agreement, convertible loan agreement or debt.
(d) Conversion Events: The SAFE enables conversion only for the following events which are set in advance in the SAFE:
Exit event in which most of the company’s shareholders sold their shares;
Conversion based on a price per share in accordance with company’s valuation according to its most recent funding round (without any discount);
A transaction for sale of all or substantially all of the company’s assets;
(e) Return of Investment Amount: The investor has no right for return of its investment amount, other than through conversion to the company’s shares or to receive the amount that it would have received in case of conversion in the event of sale of all of the company’s shares. There is no defined date for return of investment amount, other than in case of voluntary or involuntary liquidation, the appointment of receiver or special administrator or general assignment of rights to company’s creditors. In those events, the SAFE is subordinated to the creditors, other than parity with preferred shareholders (but still subordinated to creditors and superior to rights of ordinary shares). In addition, the SAFE determines that return of investment amount to investor in the foregoing events is only to the investment amount (and not more than the investment amount).(f) Other Consideration: The company will not be obligated to provide any form of compensation or consideration (including any intertest rates or assets or royalties) to the investor during the period between the investment and the conversion into company’s shares.
(g) Discount Rate: The discount to the investor in conversion is not based on the length of time between the investment and the conversion.
(h) No Security: The investor has not received any guarantee, lien, pledge or other security to secure its investment.
(i) Deduction of Expenses: The company will not claim any financing expenses or deduction with respect to the SAFE.
(j) Equity Round Conversion: The conversion of the SAFE as result of a funding round will be in a funding round in which at least 25% of the raised funds are from investors, who are not SAFE investors.
(k) Sale of Conversion Shares: Sale of the shares received as result of conversion of the investment amount raised by the SAFE will be only after 12 months from the execution of the SAFE or 9 months from the conversion date. A sale of those shares may occur earlier if the sale of the company’s shares is made by most of the company’s shareholders and the consideration is paid by the purchaser (and not the company), which is a third party not related to the company or to any shareholder holding more than 25% of the company’s shares. The price per share received by the SAFE investor in such a sale will be the same as the price received by other shareholders for the same class of shares (without considering any discount set forth in the SAFE).
Please note that as indicated in the guidance, if a company or a SAFE does not satisfy the safe harbor requirements, then the investment will be reviewed based on its specific circumstances in order to determine whether it would be classified as an advance payment on account of equity investment for tax purposes, debt repayment with interest income to the investor, or other type of transaction.
The foregoing safe harbor requirements are very specific and drafting the terms of the SAFEs matters. Not all SAFEs will satisfy those requirements. Some SAFEs have optional conversion provisions which will not satisfy the safe harbor requirements. Some companies will not satisfy the R&D requirements. Therefore, investors as well as companies raising funds through SAFEs should carefully consider the terms of the SAFEs to avoid unnecessary tax consequences.
.By Dr. Ziv Preis, Partner and Co-Head of the Technology, Corporate and M&A Department
This newsletter is provided for informational purposes only, is general in nature, does not constitute a legal opinion or legal advice and should not be relied on as such. If you are seeking legal advice, it is essential to review the specific facts of each case in detail with a qualified lawyer.