Convertible Notes, SAFEs and eligibility for VC tax concessions
As more companies faced down-rounds following the recalibration to startup valuations in 2023, we’ve seen a significant rise in the use of convertible notes and simple agreement for future equity (SAFE) notes in Australian venture capital funding rounds.
These instruments allow companies to raise capital without immediately setting a valuation, with the valuation discussion deferred to the next equity round. They are generally simpler and faster to negotiate than a priced equity round, making them particularly attractive to pragmatic founders looking to maintain momentum during uncertain times.
Despite their growing popularity, not all convertible notes and SAFEs qualify as eligible venture capital investments under Australia’s regulatory framework. Where they don’t qualify, fund managers and investors in early-stage venture capital limited partnerships (ESVCLPs) and venture capital limited partnerships (VCLPs), will not be afforded the tax concessions that these structures are set up to take advantage of.
This article explores when convertible notes and SAFEs meet the criteria for being an eligible venture capital investment, when they may fall short and provides a guide for fund managers and founders navigating this increasingly nuanced terrain.
What is an Eligible Venture Capital Investment (EVCI)?
To qualify as an EVCI, the investment in the investee company or unit trust must meet a range of criteria, including:
Form of investment | Shares, units, options to acquire shares or units, or convertible notes (excluding those classified as debt interests). |
Risk and capital limits | The investment must be 'at risk' (s 118-430) and must not exceed 30% of the partnership’s committed capital. An ‘at risk’ investment broadly means that the investor must not be involved in any arrangement that guarantees or maintains the value or return of the investment. If the convertible note or SAFE contains features such as put options or other mechanisms designed to protect the investor’s downside, they may not qualify as EVCIs. |
Australian presence | Companies must be Australian residents. Trusts must carry on business in Australia and meet residency or beneficial interest thresholds. |
Asset and employee location | If the investor has no prior holdings, the entity must have more than 50% of its assets and more than 50% of its employees in Australia during the 12 months from the time the investment is made. |
Unlisted | The entity must be unlisted or delisted within 12 months of investment. |
Asset value thresholds |
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Business activity requirements | The entity must meet at least two of the following:
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What are the primary benefits of EVCIs?
Investments that qualify as EVCIs under the ESVCLP or VCLP regimes benefit from significant tax concessions designed to encourage investment in innovative, early-stage Australian companies, including:
- flow-through tax treatment for the partnership (ie partners are taxed according to their separate individual tax status);
- fund managers can claim their ‘carried interest’ (ie management fee) on capital account, rather than revenue account.
- resident and non-resident limited partners in an ESVCLP are exempt from tax on their share of the profits made by the partnership (provided that certain conditions are met). For VCLPs, foreign investors are exempt (provided that certain conditions are met);
- limited partners in an ESVCLP receive a non-refundable carry forward tax offset of up to 10% cent of their eligible contributions.
Convertible notes: when will they be an EVCI?
Convertible notes are widely used in venture financing. Their eligibility as EVCIs depends on whether they are classified as ‘debt interests’ under s 974-20 of the ITAA97. If the convertible note is a debt interest, it is (subject to very limited exceptions) not an EVCI.
As a general principle, convertible notes will be a debt interest where there is a non-contingent (or effectively non-contingent) obligation on the company to repay to the noteholder the amount for which the notes were issued.
Practically, a note that gives the noteholder the right to elect whether to convert the notes into equity and provides for the notes to be redeemed for their face value at maturity to the extent that the noteholder does not make an earlier conversion election, would likely be considered debt for tax purposes and are generally not EVCIs. This is because there is effectively a non-contingent obligation on the issuing company to repay the face value of the note, particularly if maturity occurs within 10 years. If maturity is after 10 years, a present value calculation is required to assess whether the instrument is debt.
In contrast, a convertible note may be treated as equity if:
the issuing company holds the conversion right or the note includes certain ‘trigger events’ (e.g. qualifying capital raise, trade sale or IPO) upon which the company can elect to convert the note or upon which conversion automatically occurs; and
there is a real and genuine possibility of the relevant trigger event occurring before maturity, such that redemption obligation of the company is contingent on uncertain events.
SAFEs: when will they be an EVCI?
SAFEs are popular among startups for their simplicity and flexibility. Key features of a typical SAFE include:
- no maturity date or interest payments;
- valuation caps and discount rates; and
- conversion into equity during future financing rounds.
A standard SAFE (such as those based on the Australian Investment Council template) is typically considered equity rather than debt for tax purposes, as there is not an effectively non-contingent obligation on the issuer to repay the amount subscribed under the note.
However, to the extent that the terms of a SAFE note are modified, those amendments will need to be checked to confirm whether they change its characterisation from equity to a debt instrument for tax purposes, disqualifying it from EVCI status.
While instruments like convertible notes and SAFEs remain valuable tools for early-stage funding, their qualification as EVCIs depends on careful structuring and legal analysis.
If you're a fund manager or founder looking to understand when a particular instrument will be an EVCI, please reach out to our team for guidance.
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