SAFE Notes, Convertible Notes, and Startup Equity: A Shariah Assessment

If you invest in startups, work in one or have founded one, you likely hold equity that exists only on paper: a SAFE note, a convertible note, stock options, or unvested shares. Before asking when zakat is due on any of these instruments, the prior question is whether holding or issuing them is permissible. This article addresses that question. The zakat analysis follows in the companion articles.

The Instruments

A SAFE note (Simple Agreement for Future Equity) is a contract where an investor pays cash today in exchange for shares to be issued at a future triggering event, typically the company’s next funding round or an acquisition; no shares transfer at contracting, and the SAFE converts into equity at a price determined by a pre-agreed formula, such as a valuation cap, a discount rate, or both.[1] A convertible note is structured as a loan from the investor to the company, converting to equity at a future date, typically at a discount to the next round’s price; until conversion, it is a debt instrument with a prior claim on company assets.[2] Stock options give an employee the right to purchase company shares at a fixed price (the strike price) at a future date; the employee owns no shares until the option is exercised, the strike price is paid, and the shares vest.[3] Unvested equity refers to shares granted on a vesting schedule under which ownership transfers incrementally; until vesting occurs, the grant is conditional, and unvested shares revert to the company if employment ends before the schedule is met.[4]

The Default Rule

The foundational rule governing contracts and conditions in Islamic jurisprudence is permissibility: a contract is presumed valid unless a specific prohibition is established by text or by consensus.[5] This rule is the starting point for analyzing each instrument, and the analysis proceeds by identifying whether any established prohibition applies, not by searching for a positive textual authorization.

SAFE Notes

The permissibility of a SAFE turns on two questions: whether a sale at a future-determined price is valid under Islamic contract law, and whether the structure contains any element classical jurists identified as prohibited.

On the first question: the majority position across all four schools holds that a sale is invalid when the price is unknown to both parties at the time of contracting, because ignorance of the price (jahalah fi al-thaman) produces the prohibited uncertainty (gharar) that exposes both parties to harm. The Hanafis treat such a sale as defective (fasid); Ibn ‘Abidin records the rule as: selling a thing at its value, or per the judgment of so-and-so, is not valid.[6] The Maliki, Shafi’i, and Hanbali schools hold the same position, each requiring that the price be known at contracting and treating a sale at an undetermined market-referenced price as invalid for gharar.[7]

A minority position in the Shafi’i and Hanbali schools holds that such a sale is valid, on the basis that consent (rida) is the operative condition of a valid sale, and that a buyer who agrees to pay the market price demonstrates consent more fully than one who haggles, because he accepts the seller’s expertise in what the goods are worth. Ibn Taymiyyah selects and defends this minority position. Ibn al-Qayyim articulates its evidentiary basis: "there is nothing in the Book of Allah, nor the Sunnah of His Messenger, nor the consensus of the Ummah, nor any companion’s statement, nor valid analogy that prohibits it," and the analogy to a marriage contracted at the equivalent dower (mahr al-mithl), which the entire Ummah accepts as valid, confirms that a transaction at a determinable price standard is not inherently defective.[8]

A SAFE presents a stronger case for validity than the classical scenario the minority position addresses. In the classical debate, the price standard is an external market price that neither party controls and that may shift between contracting and resolution. In a SAFE, the conversion formula is fixed in the contract itself, agreed to by both parties, and resolves at a defined triggering event that both parties know in advance. The total capital contribution is fixed at contracting; the only open variable is the per-share price, which is not uncertain in the prohibited sense but determinable by the formula both parties accepted. The investor’s consent to these exact terms is not in question. The uncertainty that the majority found invalidating in the classical case — where neither party knows what the price standard will yield at the time of contract — is substantially reduced in the SAFE structure, where the formula is specified, and both parties can calculate the range of outcomes at contracting.

On the second question: a SAFE is a sale, not a loan. The prohibition on combining a sale and a loan in a single transaction is established by hadith,[9] but no loan element exists in a SAFE. The prohibition on a loan that generates benefit for the lender (qard jarra naf’an), which represents consensus even where specific supporting narrations are disputed,[10] likewise does not apply, because the investor is not lending. The investor is paying for future equity. There is no debt, no repayment obligation, and no return structured as interest. Contemporary analysis of startup financing instruments has confirmed this characterization: a SAFE is not a debt instrument and does not implicate the prohibitions on interest-bearing lending.[11]

Convertible Notes

A convertible note is permissible when it carries no interest. The evidence that lending and collateralizing debt are not themselves prohibited is well-attested: the Prophet pledged his armor to a Jewish merchant in exchange for provisions for his family.[13] What is prohibited is charging interest on a loan.[14]

A convertible note that accrues interest while outstanding involves riba and is impermissible. Most convertible notes are structured with an interest rate, and because early-stage ventures are cash-constrained, that interest normally accrues rather than being paid out, making it a growing obligation carried by the company until conversion or repayment.[15]

A note that converts principal to equity at a discount, with no interest accruing on the outstanding balance, admits two characterizations. The first treats conversion as a permissible equity sale: the outstanding debt is extinguished and equity is issued in its place, with the discount reflecting the price terms of that equity transaction rather than any return on the loan. The second looks at the same chain of events as a whole and reaches a different conclusion: the holder extended a loan and received, in lieu of interest, a discounted acquisition price at conversion; the discount is therefore a benefit accruing to the lender by reason of the loan, and any loan that generates benefit for the lender is riba.[16] I lean toward the second characterization but have not reached a firm conclusion. Muslim founders raising capital through convertible instruments should, on either view, prefer interest-free structures or, better, SAFE notes, which avoid the debt characterization entirely.

Stock Options and Unvested Equity

A stock option received as employment compensation is a gratuitous right: the employee pays nothing for the option itself and acquires by it only the conditional entitlement to purchase shares at a fixed price if she chooses to exercise it.[17] The option is not a sale, because no shares transfer at the time of grant. It is not a loan, because nothing is lent. It contains no interest element. Receiving a right without consideration is permissible; classical jurists treat gratuitous conferral of rights as gifts, and gifts are valid. The analysis at the permissibility level therefore turns on whether the underlying employment contract is valid, not on any inherent defect in the option instrument itself.

Unvested equity involves shares granted conditionally on continued employment through a defined vesting schedule, typically four years with a one-year cliff, after which ownership vests in monthly installments.[18] Unvested shares that expire if employment ends before vesting have no independent prohibited element; compensation contingent on the completion of a defined service is a permissible structure, well established from the majority position on the unilateral performance contract (ji’ala).[19] The permissibility question therefore reduces, as with options, to whether the underlying employment contract satisfies the requirements of a valid hire: that the service, compensation, and period of engagement are sufficiently defined. The instruments themselves introduce no additional prohibition.

Part 2 addresses when zakat becomes due on SAFE notes, convertible notes, stock options, and unvested equity before any liquidity event. Part 3 addresses how to calculate zakat when equity becomes accessible and what happens at the liquidity event.

Notes

1. Smith & Smith, Entrepreneurial Finance: Venture Capital, Deal Structure & Valuation, 2nd ed. (Stanford University Press, 2019), pp. 155-156.

2. Kupor, Secrets of Sand Hill Road: Venture Capital and How to Get It (Penguin, 2019), Ch. 2.

3. Kupor (2019), Ch. 6.

4. Kupor (2019), Ch. 6; Pearce & Barnes, Raising Venture Capital (Wiley Finance, 2006), pp. 193-194.

5. Ibn Taymiyyah, Majmu’ al-Fatawa, vol. 29, pp. 132-167.

6. Ibn ‘Abidin, Radd al-Muhtar ‘ala al-Durr al-Mukhtar, vol. 4, p. 505.

7. al-Baji, al-Muntaqa Sharh al-Muwatta’, vol. 5, p. 41; al-Nawawi, al-Majmu’, vol. 9, p. 404.

8. Ibn Taymiyyah, al-‘Uqud, ed. al-Misri, p. 434; Ibn al-Qayyim, I’lam al-Muwaqqi’in, vol. 4, pp. 5-6.

9. Abu Dawud, Sunan Abi Dawud, no. 3504; al-Tirmidhi, Jami’ al-Tirmidhi, no. 1234.

10. al-Bayhaqi, al-Sunan al-Kubra.

11. Al-Jandal, ‘Abd al-Rahman ibn Sami, "Startup Financing Contracts," SNB 15th Symposium on the Future of Islamic Banking (2024).

12. al-Bukhari, Sahih al-Bukhari, no. 2509; Muslim, Sahih Muslim, no. 1603.

13. Quran 2:275-279; Muslim, Sahih Muslim, no. 1584.

14. Smith & Smith (2019), p. 138.

15. The operative rule is the principle that any loan generating benefit for the lender constitutes riba (kullu qard jarra naf’an fa-huwa riba).

16. Kupor (2019), Ch. 6.

17. Kupor (2019), Ch. 6.

18. This is well known from the majority position on the permissibility of the unilateral performance contract known as ji’ala.