MintzTech Connect Feature: Series SAFE Preferred

As we enter what we expect will be another dynamic year for the venture capital ecosystem, one theme remains constant: the need for structural clarity in early-stage financing. Founders and investors alike are seeking tools that provide greater certainty without sacrificing the speed and efficiency required to fund companies’ growth.

This mini-issue of MintzTech Connect is dedicated to an innovation in early-stage financing: the Series SAFE Preferred. Developed by the VC & Emerging Companies team at Mintz, this newly designed security blends the familiar simplicity of the now ubiquitous Y Combinator SAFE with the clear tax benefits of preferred stock and the statutory rights enjoyed by stockholders.

As actual preferred stock authorized under a filed charter, the Series SAFE Preferred provides investors with immediate stockholder rights and protections while preserving the hallmark economic terms and simplicity that make SAFEs so attractive to founders.

Crucially, this new instrument provides early-stage investors with much needed certainty regarding eligibility for the Internal Revenue Code Section 1202 Qualified Small Business Stock capital gains exemption.

The Series SAFE Preferred’s most salient feature concerns eligibility for QSBS treatment. While the SAFE was a groundbreaking innovation, it has a particular weakness — it may be characterized as a forward contract rather than “stock.” Although the form SAFE contains language reflecting that the parties’ intent that it be treated as stock for QSBS (and other) tax purposes, the IRS has never approved or agreed with this approach or provided guidance on the topic.

Because the other most common convertible security — convertible notes — are debt rather than stock and share essentially all of the same features as SAFEs (other than maturity dates and interest rates), meaningful uncertainty remains as to whether a SAFE would be treated as stock for QSBS purposes if the issue were directly addressed.

That would be a significant problem for early-stage investors who may want to claim the benefits of QSBS upon a liquidation event for their portfolio company. If a SAFE is not stock, it means that the investor’s QSBS holding period would not begin until the SAFE converted into preferred stock, and the investor may not have held the preferred stock issuable long enough to enjoy the full or partial benefits of the capital gains exclusion under Section 1202.

The Series SAFE Preferred solves this problem by ensuring that the holding period clearly begins when the investment is made (subject to the other eligibility requirements of Section 1202). The result is a security that aligns legal form with economic reality, giving investors stockholder rights at issuance without forcing companies into a premature priced round.

In addition to the clear start date for an investor’s QSBS holding period, the Series SAFE Preferred confers other benefits on investors that SAFEs do not. As a stockholder (rather than a contractual counterparty), a Series SAFE Preferred investor is entitled to the information (books and records) and limited voting and fiduciary protections of a stockholder under the Delaware General Corporation Law that SAFE holders do not have. Further, Series SAFE Preferred investors enjoy the added certainty and clarity of the liquidation preferences set forth in, and enforceable under, the issuing company’s Certificate of Incorporation, whereas comparable rights for SAFE holders are contractual in nature and untested in bankruptcy contexts.

The Series SAFE Preferred forms are now available for download and use at www.seriessafe.com, and we encourage you to review the materials and contact us to discuss implementation in your next financing.

You will not be the first. The Series SAFE Preferred is already in use by our clients, and the client spotlight in this issue focuses on one such transaction.

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