Is it 'safe' to use a convertible note for an ESIC?
The short answer is probably no, notes must convert to an equity interest to be eligible.
From an investor perspective, Esic tax benefits may be created at the time new shares are issued by a qualifying company, to a qualifying investor. Why? The law aims to incentivise equity investment, not debt or hybrid equity investment.
*eligibility criteria apply
Can I use a convertible or safe note?
Yes, a Simple Agreement for Future Equity (SAFE) or convertible notes can be used by an eligible esic, however all parties need to be aware that the ATO determine ESIC outcomes when an equity interest arieses which happens on conversion to new shares, not when the note is purchased (unless detailed tests can be met).
The issue of convertible notes is treated as debt until they are converted into equity (new shares).
But what about Safe notes? They are equity are they not? ...well not exactly… the ATO have not made any public announcement, though unofficially, these are seen as ‘an agreement to future equity’, which is not a ‘new share’ it’s an agreement to issue new shares if the terms of the agreement are met.
This is why ESIC benefits will be secure when conversion occurs, and all parties need to consider if ESIC status will be lost at that time.
What is a convertible note?
A convertible note is a debt that converts into equity. Start-ups can use them over a short term with automatic conversion to equity at a predetermined millstone or later funding round.
This may be attractive to Start-ups as it avoid placing a value on the business before it has enough operative history for a ‘full valuation’ and the investors typically receive somewhat more security and may receive or compound a coupon (interest income).
In practice, the rights to a debt in a struggling startup maybe worth little more than an equity interest, so we recommend you consider the structure fully and seek advice.
Will safe notes qualify for esic?
SAFE means ‘simple agreement for future equity’. The issue of a safe note will not qualify for esic, only the conversion will.
Some SAFE note advocates present these notes as equity, though the current tax regulatory view is they are not, for ESIC purposes at least.
How can this be? If a safe is ‘just’ a convertible note without the interest, term and loan terms, why isn’t it equity? It’s a fair question, worthy of an ATO private binding ruling, however the simple analogy is stock options, which are a rights to buy shares, rather than a share in themselves.
A safe could be seen as a ‘reverse stock option’, with capital upfront, and equity later, though in either case, the clean ‘membership’ between shareholder and company has not been established, hence no ESIC status, yet*.
Given this analysis is provided in an untested regulatory position (subject to change), it is our view that the reader should consider convertible and safe notes ineligible for esic status prior to conversion
Considering that the auditors first point of reference is typically ASIC shareholder records, and those note issues will be nowhere to be found.
Are Safe Notes popular in Australia?
Whilst convertible notes are in common use in Australia, safe notes were quite uncommon until the last 5 years.
You’ll find certain niche’s starting to use these commonly, which can be reason for query, given the issuer background and relative applicability of hybrids in ordinary investment circles.
In our view, safe notes may be appropriate for hyper growth start-ups, the future unicorn if you will, rather than a regular high growth start-ups.
Safe notes 'feel' right, if the issuer is rationally confidendent of having 10 notable investors in a room within day, fighting over one another to invest in a seed round at notional 15m-50m USD pre-money valuation. If the issuer is working hard to close a 5m pre-money round for 3 months, its time to reconsider a regular offer, it will help your ESIC eligibility as well.