SAFEs, Notes & Warrants: Not for Compensation

When a company needs to compensate someone for their services without using traditional options or stock grants, alternative methods like SAFEs, Notes, and Warrants often come into consideration. However, they come with their own complexities and are not typically a good fit to use as compensation for service providers. 

Here are some examples of how this can arise:

Example 1: A vendor is providing a monthly service to a startup. Instead of being paid their normal rates, the vendor and startup want to just issue the vendor a SAFE for the value of their services with some agreed upon terms.

Example 2: A company takes too long to issue options to a group of employees. Value goes up and in order to “true up” the employees, the company wants to grant the employees SAFEs for the difference in value.

In this article, we’ll explain the reasons why you should not leverage SAFEs, Notes, or Warrants for compensation.

Why SAFEs, Notes, and Warrants Are Not a Fit

Tax Rules Related to “Property” as Compensation

IRC §83(a) says that any property exchanged for services is taxable. For example, if an employee is providing services to a startup and the startup gives them a car for the services, then the value of the car would be considered taxable income to the employee and the company would need to withhold taxes for the “payment” as well. 

If stock (considered “property” by the IRS) is given to a service provider and the stock is below fair market value (FMV), then the difference between the price paid and the FMV is taxable income. The same applies when a company tries to grant a SAFE or convertible note for services. Both are considered property by the IRS, so the value of the SAFE or note is taxable. 

So, in example 1, if a startup gives a vendor a SAFE for $100k in exchange for their services, the $100k would be considered taxable income to the vendor in the same way that a $100k payment would. 

Accredited Investor and Stock Class Issues

Typically, common stock is reserved for service providers, while preferred stock is meant for investors. Deviating from this norm can lead to complications during due diligence in financing rounds or acquisitions. 

Preferred rounds generally require participants to be accredited investors. Therefore, even if a service provider is comfortable with the tax implications described above, they should only receive a SAFE or note if they meet the criteria of an accredited investor. This ensures compliance with securities laws and smooths out potential issues in future transactions.

Warrants

Warrants give a person or entity the right to purchase stock in the future at a fixed price, much like a stock option. They're commonly used in the startup world to add a “sweetener,” or incentive, for certain investors in a financing round. 

However, if warrants are issued in exchange for services, the IRS treats them as stock options, meaning they must comply with the rules for stock options, including issuance at fair market value (FMV). So instead of trying to use warrants in lieu of stock options, it's best to just issue stock options given that the IRS will treat warrants in this context as options.

Structuring Equity Stake Arrangements

Unfortunately, with very limited exceptions (specifically, issuing options with a fixed exercise date or issuing options to a narrow subset of independent contractors), there is no secret way around issuing equity at FMV in startups. But there are strategic ways that startups can tackle nuanced situations.

For example, in the situations described at the top of the article:

Example 1 (Vendor): Startups can issue options with FMV strike price (or potentially less for certain qualifying contractors) and use milestone-based vesting to achieve the goals of getting vendor equity upon performance of certain services.

Example 2 (True Up): Startups can issue options coupled with a right to a bonus (which of course comes with its own set of rules to consider) which only kicks in when the optionee exercises their option. Alternatively, the company could consider issuing phantom stock to the employees to give them the right to a payment upon certain qualifying events.

Key Takeaways

• Not Designed for Compensation: SAFEs, Notes, and Warrants are investment tools and are not typically suited to be used for compensation of service providers.
• Tax Implications: Any property, including SAFEs or notes, given for services is taxable, with the value considered income.
• Accredited Investors: Preferred stock and similar instruments giving the right to preferred stock should only go to accredited investors.
• Warrants as Options: Warrants issued for services are treated as stock options and must follow similar rules, including fair market value (FMV) requirements.
• Alternative Strategies: Use FMV-priced options with milestone-based vesting for vendors or options with a bonus right for employee "true up" situations.

If you need further clarification on providing equity compensation options to your employees and service providers, reach out to us today. We can guide you in selecting the best options for your early stage company.