Angel 101: Terms & Tech
There are two more advanced things you may hear about related to SAFEs.
Anti-Dilution
Post-money SAFEs are anti-dilutive until they convert to equity. SAFEs don’t cause new shares to be issued. This means no matter how many SAFEs are signed after yours, you always know at least how much of the company you are going to receive for the money you invested. However, once your SAFEs convert to equity, they become dilutive like all equity.
Apologies if this sounds basic, but it’s a good reminder:
Dilution happens when new equity investments come in. These new investments revalue the company (hopefully up) and cause more shares to be issued.
After this happens, you’ll end up owning a smaller percentage of the company because your number of shares has stayed the same while the overall number of shares has increased to accommodate the new investors.
But if the new investors value the company at a higher price than when you invested (an up round) the value of the shares you hold increases. So, on paper, your investment has become more valuable. aka: dilution is not a bad thing.
Maintaining your percent ownership in the company would require you to invest more money to buy more shares. Sometimes VCs have “pro rata” rights that allow them to do this. Angels and SPVs usually don’t. We’ll discuss this more later.
QSBS
QSBS stands for Qualified Small Business Stock. Early-stage startup investing is a very tax-advantaged asset class. If your startup investment meets certain criteria, you won’t have to pay federal taxes on your gains. Crazy right?
One of those criteria is the length of ownership. QSBS rules (very simplified here) state you have to own the equity for 5 years to get the favorable tax treatment. Obviously, this is confusing if your investment sat in a SAFE note for a couple of years since SAFEs technically aren’t equity. Is the QSBS clock ticking during this time or not? It is a grey area in the IRS code at this point. The standard Y-Combinator SAFE note now includes a clause that states the SAFE should be treated as equity for tax purposes. No case law has been settled on this yet, so we’ll see how it unfolds. On the plus side, chances are someone with deeper pockets and more at stake will have this figured out before it hits any of us.
We’ll talk about QSBS more later, but generally, if one of your investments has a positive exit, your tax person will guide you.