The Israel Tax Authority (“ITA”) published on January 29, 2025 an update to its guidelines from May 16, 2023 that sets out the conditions under which SAFE (Simple Agreement for Future Equity) agreements will be classified as equity instruments and not as interest bearing debt (“Updated Guidelines”).
SAFE investments are a common instrument used as an investment in the Hi-Tech industry, as they offer several advantages:
- raising funds quickly through a simple agreement;
- limited negotiations between the investor and the company (no need for valuations and/or determination of the price per share on the date of such fundraising until the future date of a transaction, typically involving a determined discount on the price per share);
- do not dilute existing shareholders at the time of investment;
- fewer administrative burdens;
- SAFEs convert into equity in future financing rounds, which helps ensure investors get a fair deal if the company’s valuation increases;
- no maturity date, so there is no pressure on the company to repay the investment or force a liquidation event by a certain time;
- legal costs are often lower compared to traditional equity investment deals;
- since the SAFEs only convert into equity when the company raises another round, both the investors and the founders are motivated to hit certain milestones that lead to future funding rounds;
- SAFEs don’t carry interest or require repayment if no future funding round occurs.
A SAFE is a hybrid instrument and therefore the issue at hand is whether the SAFE should be classified as debt or as an equity investment for Israeli tax purposes as no shares are issued upon the fundraising. In addition, the instrument includes a discount which could be characterized as an interest payment.
The main changes of the Updated Guidelines in reference to the original guidelines are as follows:
- Update of the maximum SAFE amount for one investor: the amount was increased from NIS 40 million to USD 20 million.
- Mandatory Conversion: in the event of a fundraising round in which a) an amount exceeding 40% of the company’s fully diluted share capital is raised (before the investment and before the allocation of shares), or b) an amount exceeding 10 times the cumulative amount of the company’s outstanding SAFE agreements is raised, there is an obligation to convert the SAFEs into shares. It is clarified that this arrangement does not prevent the conversion of the SAFEs into shares as part of a fundraising round that does not require a conversion.
- Discount Alternatives: pursuant to the original guidelines the discount rate cannot change as a linear function of time. The Updated Guidelines enable a SAFE in which a variable discount rate is determined, up to 3 levels representing 3 discount rates (where the discount rate in each level can be conditioned as a function of time or dependent on the achievement of milestones), while the maximum discount rate will be reached after 3 years from the date of signing the SAFE agreement.
- Broadening the possibility of converting the SAFEs at a predetermined date: the conversion at a predetermined date can be at a predetermined value, which is a nominal amount, or at the value of the share in the company’s last fundraising round or the next fundraising round, without a discount or with a predetermined discount.
In addition to the main issues described above, the Updated Guidelines include additional requirements and terms that do not deviate from the original guidelines.
The Updated Guidelines clarify that failure to comply with the conditions set forth in the guidelines does not necessarily mean that the SAFE will not be classified as an equity instrument.
The Updated Guidelines apply to SAFE agreements that are signed as of January 1, 2025 and no later than December 31, 2026 or until other guidance is published by the Tax Authority, and can also be used to clarify the original guidelines that were issued back in 2023.
Conclusion
SAFEs that would meet the Updated Guidelines would automatically be classified as equity investments which is a safe harbor to the investor for the classification of its investment as an equity instrument rather than interest-bearing debt. We have vast experience with SAFE instruments and will be happy to assist in reviewing current and/or new SAFEs so that the investment would be made in a safe manner.
For the updated guidelines click here
The content is provided for informational purposes only and is not intended to be comprehensive. It does not serve to replace professional legal advice required on a case by case basis.
