Disclaimer: The terms below are discussed in the context of financing that occurs in the United States for Early-Stage Technology companies. We would strongly advise anyone to seek out a professional to help with their individual company circumstances.
Earlier this week, we participated in a Clubhouse panel discussion on early-stage financing considerations – SAFE’s vs. Convertible Notes vs. Priced Rounds. Below is some information on SAFE’s vs. Convertible Notes, and we will save the discussion on Priced Rounds for a separate post.
Why the popularity of Convertible notes? Start-Ups use convertible Notes at early stages to raise money to defer valuation questions to a later stage. These are debt financing agreements with a conversion feature that turns them into equity – Usually Preferred Stock. These are usually used in early-stage seed deals with your early investors but can also be used at later funding round stages, usually as a bridge-financing tool. Convertible Notes have a stated interest rate and maturity date. Maturity Dates on convertible debt from Venture Capitalists usually average around 12 to 18 months, sometimes even less than a year, making this type of agreement ideal if you’re coming off of zero revenue and have high expectations for an impending product launch. Extensions are the norm if you are in the midst of a Series-A financing round.
It is critical for founders to understand the terms of their convertible notes as discounts, valuation caps, warrants, and conversion mechanics can greatly impact future financing rounds and adversely impact your goals if not done right. Having a great lawyer and finance professional to help you navigate your financing round is critical to ensure that the right incentives are put in place to satisfy both the founder and investor.
So what is the accounting for Convertible Notes?
Convertible Notes are loans – so they are recorded on the Balance Sheet of a company as a liability when they are made. Depending on the debt’s maturity date, they can either be shown as a current liability (loans maturing within 12 months) or as a Long-term liability (loans maturing over 12 months).
From an accounting point of view, care must be taken to not mistakenly record any of the deposits as revenue – Surprisingly, this is more common than you think. We, as the accountants, are making a lot of year-end adjustments to ensure the movement of money from one place to another is recorded correctly for financial statement disclosure and tax disclosure purposes. Care must also be taken to match the actual bank deposits to the convertible note agreements as bank/wire fees can also cause variances.
What about the Interest?
Interest on convertible notes needs to be calculated and accrued – which means recorded as a liability on the balance sheet each month and on the Income Statement as an ‘Interest Expense.’ This interest usually converts into equity along with the principal and is usually not expected to be paid out in cash. Due to this fact, the interest rates on convertible debt should not be too much higher than the AFR rates set by the Treasury Department as the main incentive for investors is not to earn the maximum interest of their investment.
Tax Consideration – When the convertible note converts into equity, a 1099-INT/OID form may need to be issued to the investors depending on the terms of the conversion. So it’s a good idea to have your investors complete W9 forms to get their tax information when you are closing out a financing round.
Accounting on conversion:
When the convertible notes are converted into Equity – the loans and their accrued interest are in effect moved from the balance sheet’s liability section to the balance sheet’s equity section based on the priced round. Since convertible note holders usually take a risk at an earlier stage than the Series A investors, they may have a discount provision in their convertible notes.
For example, for a note holder who invested $500,000 at a 20% discount. If the Series A round investors are paying $2 per share, the note will convert into the same number of shares at a 20% discount – $1.60 per share. So $500k would purchase 312,500 shares ($500,000/$1.60 per share) for the note holder, whilst the Series A investors will get 250,000 shares for their investment of $500,000 ($500,000/ $2 per share).
For accounting purposes, the company’s general ledger must always agree with the capitalization table (cap table), which is usually maintained in an outside spreadsheet or software like Carta or Captable.io. From our experience, this area of the financial statement can be extremely complex, and it’s important to keep detailed records.
The value of the $500,000 note from the example above would need to be reflected in the Equity Section of the Balance Sheet as Preferred Stock and Additional Paid-in Capital.
Preferred Stock (Par Value) – $0.0001 x 312,500 = $31.25
Additional Paid-in-Capital (Preferred Stock) = ($1.60 – $0.0001 (par value) x 312,500 = $499,968.75
If for example, there was $4,678 in Interest that had also accrued until the point of conversion that Interest would also convert into Preferred Stock 2,923.75 shares.
Preferred Stock (Par Value) – $0.0001 x 2,923.75 = $0.29
Additional Paid-in-Capital (Preferred Stock) = ($1.60-$0.0001) x 2,923.75 = $4,677.71
Since the equity above is being split into two separate accounts – ensuring proper labeling/memo’s on the actual transactions/journal entries will ensure that the investment is correctly tracked and can match the cap table to the penny.
Simple Agreement for Future Equity (SAFE Agreements):
This is an agreement between an investor and a company to invest in a company without setting maturity dates or stated interest rates. A SAFE can be viewed like a warrant, but not exactly – Warrants are options to purchase a certain number of shares at a predetermined price – while with SAFE’s, the price is not set in stone at the time the agreement is entered into. SAFE’s were created by Y-Combinator to help mitigate some of the burden on founders and investors that comes with convertible notes (interest and legal implications of debt).
Just like Convertible Notes, SAFE agreements can have valuation caps and discounts. Most SAFE agreements convert into preferred stock. Preferred Stockholders have certain dividend preferences over common stockholders as well as conversion rights.
Accounting for SAFE Agreements:
Although SAFE agreements are not debt in the traditional sense and an argument can be made to record them as Equity; in practice, we see SAFE agreements recorded as long-term debt. When it comes to recording SAFE agreements, there is no hard and fast rule; for GAAP financial statement purposes, we’ve seen SAFE’s recorded as debt and equity. Determining the ideal recording method for your SAFE agreement may come down to provisions within the agreement and an auditor’s judgment. Since there is no interest to take into account – there will be no need to book interest accruals.
SAFE agreements are meant to introduce simplicity for founders raising capital at an early stage whilst punting valuation to later stages.
Accounting On Conversion:
Similar to convertible notes, SAFE investments need to be reclassified into Preferred Stock upon conversion, so the example would be similar to the one provided in the Convertible notes section of this post, except there wouldn’t be an interest component.
Tax Considerations: SAFE Agreements would not be considered Income/Revenue when they are made or when they are converted into Preferred Stock, so we generally disclose them as Long-Term Liabilities on your tax return. If your SAFE’s are being shown as equity, they would be disclosed as Additional Paid-in-Capital for tax disclosure purposes.
One book that has greatly helped my own understanding of Startup fundraising mechanics is Venture Deals, a book written by co-authors Brad Feld and Jason Mendelson. I highly recommend early-stage founders read that book as it gives a great overview of startup fundraising mechanics.
More info on SAFE Agreements: https://www.ycombinator.com/documents/