Convertible Debt Vs. SAFEs: What Qualifies As Qualified Small Business Stock?

Small businesses have long been the heart of the American economy. In 1993, Congress introduced Section 1202 of the Internal Revenue Code to fuel that momentum and encourage small business investment. Under this provision, up to 100% of an investor’s gain on the sale of Qualified Small Business Stock (QSBS) is excluded from tax. However, private equity and venture capital firms frequently have difficulty determining whether convertible debt or Simple Agreements for Future Equity (SAFEs) qualify as QSBS for the Section 1202 gain exclusion. In this article, we attempt to clarify where these potential opportunities may exist.

Qualifications for "Stock"

To potentially qualify for the Section 1202 gain exclusion, the stock must be obtained in an original issuance from a C corporation. The definition of "stock" includes both voting and nonvoting stock, and also includes both common and preferred stock. Section 1202 stock does not include stock issued by an S corporation, unexercised incentive stock options, unexercised nonqualified stock options, stock appreciation rights, restricted stock units, unexercised warrants, phantom equity, or other bonus arrangements.

Both convertible debt and SAFEs can potentially qualify as "stock" for purposes of Section 1202. But the characterization may be questioned when the parties elect to issue an interest whose form is "debt" in a convertible debt instrument, or a "hybrid" in the case of a SAFE. This question frequently is relevant when determining whether "stock" was issued for purposes of Section 1202, or determining when such stock was deemed to be issued. Under Section 1202, the timing of the original stock issuance is also important, because there is a minimum five-year holding period requirement.

A Look at Convertible Debt

Convertible debt allows a company to borrow money from a lender where both parties agree that all or part of the loan can be converted by the creditor into the debtor’s stock at a later time. A common issue with convertible debt is the timing of its qualification as "stock" for Section 1202 purposes, which is important regarding the five-year holding period requirement. Ideally, the convertible debt would qualify as "stock" when the loan is issued, rather than the time when it is later converted into the debtor’s stock. However, the principles under IRC Section 385 may preclude such stock treatment prior to conversion.

The regulations, together with relevant case law provide guidelines to determine if a debtor-creditor relationship exists or if a corporation-shareholder relationship exists. Under IRC Section 385(b) and pursuant to the Court’s ruling in Gilbert v. Commissioner, 248 F.2d 399 (2d Cir. 1957), the following factors should be considered:

• Whether there is a written unconditional promise to pay on-demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest;
• Whether there is subordination to or preference over any indebtedness of the corporation;
• The ratio of debt to equity of the corporation;
• Whether there is convertibility into the stock of the corporation; and
• The relationship between holdings of stock in the corporation and holdings of the interest in question.

IRC Section 385(c) would normally prevent the borrower from claiming that the convertible note was "stock," once these factors are considered. If the noteholder and the creditor conclude that these factors instead indicate equity status, then the convertible note would be treated as stock provided that both parties consistently reflect such treatment on their respective tax filings from the date of issuance. There are some collateral consequences, however. For instance, this would mean treating amounts paid regarding interest and original issue discount (OID) as taxable dividends, and taking the position that there is no OID with respect to equity.

Based on this somewhat subjective debt/equity analysis, a taxpayer may be able to conclude that convertible debt is "stock" for Section 1202 purposes. Furthermore, any actual conversion of the convertible note into stock should not disturb the previous treatment as stock for Section 1202 purposes. Section 1202(f) provides that if any stock is acquired solely through the conversion of other stock, and if the converted stock is QSBS in the hands of the taxpayer, then the acquired stock will be treated as QSBS. A tacked holding period will also apply, leading to a favorable tax outcome regarding the Section 1202 gain exclusion.

Given the potential value of the Section 1202 tax savings, these complications involving convertible debt should be avoided unless the use of convertible debt is otherwise necessary.

A Look at SAFEs

A SAFE is like a convertible note in that it is convertible into stock in the future. But unlike a convertible note, the holder of a SAFE generally cannot decide whether or when the SAFE is converted into equity. Instead, a SAFE (which generally does not accrue interest) remains dormant until the issuer enters into a separate preferred stock issuance. Hence, it is the issuer that controls whether or when the holder’s SAFE is converted into preferred stock. Indeed, the issuer may never decide to do this.

SAFEs allow a company to receive cash without the legal costs typically associated with traditional convertible debt or equity raises. SAFEs also lack many rights traditionally associated with equity, such as dividend rights and the right to vote on corporate matters. Still, they are likely to be treated as equity if they are substantially certain to be converted into equity upon issuance. In many ways, SAFEs also resemble “issuer dividend-enhanced convertible stock,” (issuer-DECS), which were prevalent in the 1990s and were widely regarded as equity. It's important to note that the SAFE terminates after it converts to equity.

In any case, SAFEs are hybrid instruments that do not fall precisely within the equity classification. There are two problems with SAFEs regarding their qualification as "stock" for Section 1202 purposes. First, SAFEs lack certain economic features that are commonly associated with stock. Second, depending on the facts and circumstances, the IRS could argue that SAFE is a prepaid forward contract, a warrant, or a debt instrument. But the latter two possibities are unlikely, because of contingencies on the holder’s ability to exercise (i.e., not a warrant) and due to the lack of many debt characteristics (e.g., no sum certain payable at a fixed time in the future, and no accrued interest).

A prepaid forward contract remains a possible classification, however. A typical prepaid forward contract involves a party paying cash in exchange for an agreement to deliver a variable number of shares at the settlement date. Because ultimate delivery for some type of underlying property is commonplace between a SAFE and a prepaid forward contract, classification as a prepaid forward contract is possible. In Revenue Ruling 2003-7, the IRS addresses the tax treatment of prepaid forward contracts and acknowledges they should be treated as open transactions, indicating the issuance of preferred stock upon conversion should also be treated as a cash payment. This would ultimately satisfy a Section 1202 requirement and would trigger the commencement of the required five-year holding period for claiming the Section 1202 gain exclusion. But unfortunately, the five-year holding period would not commence when the SAFE itself is issued, if it is treated as a prepaid forward contract.

Nevertheless, SAFEs typically have an equity-like feature and have liquidation preferences on par with preferred stock. If there is a high likelihood at the time of issuance that equity financing in the foreseeable future will trigger the conversion of the SAFE into preferred stock, then it strengthens the argument that the SAFE should be treated as equity and not as a prepaid forward contract. If treated as equity, the holding period starts at issuance and tacks onto the holding period at conversion, which would be favorable regarding the Section 1202 gain exclusion from a tax perspective.

Next Steps

Ultimately, the determination of whether a convertible debt instrument or SAFE constitutes "stock" for Section 1202 purposes requires a detailed analysis of the facts and circumstances. To learn more, please contact us.