Hey SEC - In the Real World, SAFEs are Equity - August 1, 2017

Just becuase you wear a badge, that does not mean you are always right.  And technocratic analysis in the sterile environment of the ivory tower must be tested against real world facts and circumstances on the ground.

This article provides a comprehensive analysis of accounting for SAFEs, applying all relevant portions of authoritative U.S. GAAP (accounting principles generally accepted in the United States of America), as well as the "true grit" reality of facts and circumstances on the ground in the rough and tumble world of startup investing.

Analysis of the Financial Accounting Standard Board’s (the “FASB’s”) Accounting Standard Classification (“ASC”) Applied to SAFEs

1.0 Introduction and General Overview

Simple Agreements for Future Equity (“SAFEs”) are a new invention (still less than four years old), and they are unlike anything previously contemplated in the accounting rules.  In the SAFE “transaction”, the SAFE investor contributes cash to the Company and receives nothing in return except the uncertain promise of future equity only if certain future conditional events occur.  If those conditional events do not occur, the SAFE investor loses his or her investment and gets nothing in return.

In effect, the SAFE investor says, “Here Mr. / Ms. Founder.  Here is some cash financing for your new startup Company.  Use it as you see fit – for salaries and other general operating expenses, or whatever you wish – it’s really up to you.  I’m fine with having no issued shares, for now, and also no Board seat and even no vote on any matters affecting the Company.  I trust you to issue equity shares to me when the time is right, according to your judgement.”

If SAFEs are not additional paid-in capital, within equity; what, pray tell, are they?  Debt??  Come on.

SAFE investors face three potential outcomes:

  1. Lose their money, because the Company fails;
  2. Lose their money, because the Company generates revenues and become self-sustaining, and managements decides never to do a preferred stock financing (according to one well-known early-stage VC fund manager, this happens for approximately 10% of all SAFE investments!); or
  3. Earn between 200% and 500% return on investment upon the conversion of their SAFE investments into shares of preferred stock (and later potentially earn a lot more when they sell their shares of preferred stock in a merger or IPO

SAFE investments have risk-reward characteristics of venture equity – not debt.

1.1 How SAFEs Work

The hope, of course, is that the Company will grow and will later execute a round of preferred stock financing.  If that happens, the SAFE investments will convert into shares of preferred stock at the Conversion Price.  (If the Company does not do a round of preferred stock financing, the SAFE investors will lose their investment, with nothing to show for it.) 

The Conversion Price, when, and if, the SAFEs are converted into shares, will be calculated as the lesser of:

  • (Discount Rate) x ((Pre-Money Valuation) / (# of Fully Diluted Outstanding Shares)); or
  • (Valuation Cap) / (# of Fully Diluted Outstanding Shares).

And the number of shares issued will be:

                   ($ Amount Invested by SAFE Investor) / (Conversion Price).

Thus, if the SAFE investments pay off at all, the SAFE investors receive a variable number of shares upon conversion.  The number of shares to be received upon conversion cannot be known or calculated at the time of the SAFE investment, because two of the key factors in determining the number of shares, the Pre-Money Valuation and the number of fully diluted shares outstanding just prior to conversion, cannot be known at the time of the SAFE investment, and can be known only at the time of conversion.  Even in the best (and hoped for) case of the Conversion Price being based on Valuation Cap, still the number of fully diluted outstanding shares just prior to conversion cannot be known at the time of the SAFE investment.

1.2 The Contractual “Rights” of Safe Investors – Effectively Are No Rights At All

Although the SAFE contracts stipulate various “rights” for SAFE investors in the event of a change of control or dissolution event, in reality, the SAFE investors have no enforceable rights at all.  This reality is due to the fact that the Company’s cofounders hold nearly 100% of the outstanding Common Stock of the Company, and thereby hold absolute control over all possible scenarios and outcomes of the SAFEs.  An important word to understand in the contractual rights clauses in the SAFE agreements is IF

“IF there is an Equity Financing before the expiration or termination of this instrument, the Company will automatically issue to the Investor either: (1) a number of shares of Standard Preferred Stock equal to the Purchase Amount divided by the price per share of the Standard Preferred Stock, if the pre-money valuation is less than or equal to the Valuation Cap; or (2) a number of shares of Safe Preferred Stock equal to the Purchase Amount divided by the Safe Price, if the pre-money valuation is greater than the Valuation Cap.”  But whether or not an Equity Financing ever occurs is entirely under the control of the cofounders of the Company, who hold nearly 100% of the outstanding Common Stock of the Company.

“IF there is a Liquidity Event (change of control) before the expiration or termination of this instrument, the Investor will, at its option, either (i) receive a cash payment equal to the Purchase Amount (subject to the following paragraph) or (ii) automatically receive from the Company a number of shares of Common Stock equal to the Purchase Amount divided by the Liquidity Price, if the Investor fails to select the cash option.”  But, whether or not there is a Liquidity Event is entirely under the control of the Company’s cofounders, who own nearly 100% of the outstanding Common Stock of the Company.

“IF there is a Dissolution Event before this instrument expires or terminates, either (i) the Investor shall notify the Company that the Investor elects to receive from the Company a number of shares of Common Stock equal to the Purchase Amount divided by the Liquidity Price, or (ii) if the Investor fails to notify the Company of the intent to receive stock, the Company will pay an amount equal to the Purchase Amount, due and payable to the Investor immediately prior to, or concurrent with, the consummation of the Dissolution Event. The Purchase Amount payable to Investor pursuant to Section 1(c)(ii) will be paid prior and in preference to any Distribution of any of the assets of the Company to holders of outstanding Capital Stock by reason of their ownership thereof. IF immediately prior to the consummation of the Dissolution Event, the assets of the Company legally available for distribution to the Investor and all holders of all other Safes (the “Dissolving Investors”), as determined in good faith by the Company’s board of directors, are insufficient to permit the payment to the Dissolving Investors of their respective Purchase Amounts, then the entire assets of the Company legally available for distribution will be distributed with equal priority and pro rata among the Dissolving Investors in proportion to the Purchase Amounts they would otherwise be entitled to receive pursuant to this Section.”  But, in the event of a Dissolution Event, whether or not there are any funds available to distribute to the SAFE investors is entirely under the control of the Company’s cofounders, who own nearly 100% of the outstanding Common Stock.  It is entirely within their control to operate the Company until there is no cash left in the bank account, and in that case, the SAFE investors will lose their entire investments and get nothing in return.  And this is not an esoteric exercise in imaginative thinking.  This is typical of many real SAFE investments!

Moreover, if the Company is successful enough to generate revenues and become self sustaining, the Company can choose never to raise a preferred stock financing; and in that case, the SAFEs would never convert to preferred stock.  In this scenario, the SAFE investors could face the prospect of not getting a return on their investment for a very long time, if ever, and could actually completely lose their investment, with nothing to show for it, and with no legal recourse!  And again, this is not an esoteric exerice in imaginitive thinking.  This kind of stuff is happening!

Because the cofounders, who hold nearly 100% of the outstanding Common Stock and voting power of the Company, control every IF contingent outcome, effectively and in reality, the SAFE investors very nearly have no enforceable rights at all.

2.0 ASC 480 – “Distinguishing Liabilities from Equity”

2.1 Scope Analysis

The stated scope of ASC 480 is very broad.  ASC 480-10-15-3 states, “The guidance in the Distinguishing Liabilities from Equity Topic applies to any freestanding financial instrument, including one that has any of the following attributes:

  1. Comprises more than one option or forward contract
  2. Has characteristics of both debt and equity and, in some circumstances, also has characteristics of an asset (for example, a forward contract to purchase the issuer’s equity shares that is to be net cash settled). Accordingly, this Topic does not address an instrument that has only characteristics of an asset.

Because the scope of ASC 480 is so broad, SAFEs are within the scope of ASC 480.

2.2 Accounting Analysis

ASC 480-10-25-14, which prescribes, “A financial instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by issuing a variable number of its equity shares shall be classified as a liability (or an asset in some circumstances) if, at inception, the monetary value of the obligation is based solely or predominantly on any one of the following:

  1. A fixed monetary amount known at inception (for example, a payable settleable with a variable number of the issuer’s equity shares).” (emphasis added)

(Sub-parts (b) and (c) obviously are not relevant.) 

The fact is the monetary value of the conditional obligation of the Company (the payoff to a SAFE investor) is not based solely or predominantly on a fixed monetary amount known at inception (the cash contributed by the SAFE investor).  Instead, the Company’s conditional obligation (the payoff to the investor) is based primarily on the following two factors:

  1. The actual value of the Company at the time the SAFE funds convert into shares of equity, as negotiated / determined in an arm’s length transaction between the Company and new, external investors (typically, the Series Seed Preferred Stockholders); and
  2. The “Valuation Cap” that is part of the SAFE agreement, and especially the degree to which the Valuation Cap is less than the actual value of the Company at the time of conversion.

In other words, the monetary value of the payoff to the SAFE investor is based primarily on the relative difference between the SAFE Valuation Cap and the actual value of the Company at the time the SAFE funds convert into shares of equity.  The Valuation Cap is typically set very low in order to give investors a strong incentive to invest in the Company at a very early stage.  Because the Valuation Cap is typically so low, relative to the actual value of the Company at conversion, SAFE investors in successful companies typically earn returns on their investments ranging from 200% to 500%, upon conversion.  (Of course, later, they have the opportunity to earn much greater returns on their preferred shares, ranging from 500% to 10,000%, when the Company does an “exit” – either an IPO or a merger.)  On the other hand, because investing in very early-stage startup companies is highly risky, SAFE investors also face a high likelihood of losing their investments and getting nothing in return.  Some SAFEs never convert into shares of preferred stock.

Furthermore, whether or not the Company ever even issues any shares of preferred stock is completely within the control of the Company.  If the Company chooses not to ever issue preferred stock, the SAFEs will never have an opportunity to be converted into preferred stock; and so, no obligation would ever even arise.

3.0 ASC 815-40 – “Derivatives and Hedging – Contracts in Entity’s Own Equity”

3.1 Scope Analysis

ASC 815-40-15-2 provides the scope of the Subtopic 815-40: “The guidance in this Subtopic applies to freestanding contracts that are indexed to, and potentially settled in, and entity’s own stock …”

The end of the paragraph, ASC 815-40-15-5 provides, “… The guidance also applies to any freestanding financial instrument that is potentially settled in an entity’s own stock, regardless of whether the instrument has all of the characteristics of a derivative instrument for purposes of determining whether the instrument is within the scope of this Subtopic.”

ASC 815-40-15-7 stipulates, “An entity shall evaluate whether an equity-linked financial instrument (or embedded feature), as discussed in paragraphs 815-40-15-5 through 15-8 is considered indexed to its own within the meaning of this Subtopic and paragraph 815-10-15-74(a) using the following two-step approach:

  1. Evaluate the instrument’s contingent exercise provision, if any;
  2. Evaluate the instrument’s settlement provisions.

If the evaluation of Step 1 (part (a) of this paragraph) does not preclude an instrument from being considered indexed to the entity’s own stock, the analysis shall proceed to Step 2 (see paragraph 815-40-15-7C).”

SAFEs do not have a contingent exercise provision; investors have already contributed their cash.  So, part (a) is not applicable. 

To evaluate SAFE’s settlement provisions (part b of ASC 815-40-15-7), we are directed to paragraph 815-40-15-7C, which says, “An instrument (or embedded feature) shall be considered indexed to an entity’s own stock if its settlement amount will equal the difference between the following:

  1. The fair value of a fixed number of the entity’s equity shares; and
  2. A fixed monetary amount or a fixed amount of a debt instrument issued by the entity.

For example, an issued share option that gives the counterparty a right to buy a fixed number of the entity’s shares for a fixed price or for a fixed stated principal amount of a bond issued by the entity shall be considered indexed to the entity’s own stock.”

We then to proceed to paragraph 815-40-15-7D, which says, “… If the instrument’s strike price or the number of shares used to calculate the settlement are not fixed, the instrument (or embedded feature) shall still be considered indexed to an entity’s own stock if the only variables that could affect the settlement amount would be inputs to the fair value of a fixed-for-fixed forward or option on the equity shares.”

We the continue to paragraph 815-40-15-7E, which says, “… The fair value inputs of a fixed-for-fixed forward or option on equity shares may include the entity’s stock price and additional variables, including all of the following:

  1. Strike price of the instrument;
  2. (b-g) are irrelevant; and
  3. The ability to maintain a standard hedge position in the underlying shares.

With SAFEs, the key variables that will affect the settlement amount is the actual pre-money value of the underlying preferred stock, as negotiated in the preferred stock financing round (if and when it happens) and the Conversion Price, which will depend both on the Pre-Money Valuation and the number of fully diluted outstanding shares. 

Thus, SAFEs are within the scope of ASC 815-40.

3.2 Accounting Analysis

While ASC 815-40 is, admittedly, complex, the fundamental principles provided are not.  ASC 815-40-25-1 says, “The initial balance sheet classification of contracts within the scope of this Subtopic generally is based on the concept that:

  1. Contracts that require net cash settlement are assets or liabilities; and
  2. Contracts that require settlement in shares are equity instruments.”

Because ASC 815-40 is a complex area of accounting – perhaps the most complex area of accounting – it will be important to keep first principles in mind.  The purpose of SAFE investments (as well as the plan of the Company) is for them to convert into shares of preferred stock of the Company.  This provides a strong “compass” that points to classification as equity, as stated in ASC 815-40-25-1.

ASC 815-40-25-4 gives the following guidance: “Accordingly, unless the economic substance indicates otherwise:

  1. Contracts shall be initially classified as either assets or liabilities in both of the following situations:
    1. Contracts that require net cash settlement (including a requirement to net cash settle the contract if an event occurs and if that event is outside the control of the entity)
    2. Contracts that give the counterparty a choice of net cash settlement or settlement in shares (physical settlement or net share settlement).
  2. Contracts shall be initially classified as equity in both of the following situations:
    1. Contracts that require physical settlement or net share settlement
    2. Contracts that give the entity a choice of net cash settlement or settlement in its own shares (physical settlement or net share settlement), assuming that all the criteria set forth in paragraphs 815-40-25-7 through 25-35 and 815-40-55-2 through 55-6 have been met.”
3.2.1 Additional Requirements for Equity Classification

ASC 815-40-25-10 provides all of the additional requirements for equity classification: “Because any contract provision that could require net cash settlement precludes accounting for a contract as equity of the entity (except for those circumstances in which the holders of the underlying shares would receive cash, as discussed in the preceding two paragraphs and paragraphs 815-40-55-2 through 55-6), all of the following conditions must be met for a contract to be classified as equity:

  1. Settlement permitted in unregistered shares. The contract permits the entity to settle in unregistered shares.
  2. Entity has sufficient authorized and unissued shares. The entity has sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative instrument could remain outstanding.
  3. Contract contains an explicit share limit. The contract contains an explicit limit on the number of shares to be delivered in a share settlement.
  4. No required cash payment if entity fails to timely file. There are no required cash payments to the counterparty in the event the entity fails to make timely filings with the Securities and Exchanges Commission (SEC).
  5. No cash-settled top-off or make-whole provisions. There are no cash settled top-off or make-whole provisions.
  6. No counterparty rights rank higher than shareholder rights. There are no provisions in the contract that indicate that the counterparty has rights that rank higher than those of a shareholder of the stock underlying the contract.
  7. No collateral required. There is no requirement in the contract to post collateral at any point or for any reason.

Paragraphs 815-40-25-39 through 25-42 explain the application of these criteria to conventional convertible debt and other hybrid instruments.”

Each of these requirements are analyzed, in turn, below.

3.2.1.a Settlement Allowed in Unregistered Shares

To qualify for equity classification, “settlement (must be) permitted in unregistered shares. The contract permits the entity to settle in unregistered shares.”

This condition is clearly met.  The Company will issue unregistered shares of preferred stock to the SAFE investors upon conversion.  Registration of the Company’s shares with the SEC is not required, or even contemplated, as part of the SAFE agreement.

3.2.1.b Sufficient Authorized and Unissued (Available) Shares

To qualify for equity classification, “(the) entity (must have) sufficient authorized and unissued shares. The entity (must have) sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative instrument could remain outstanding.”

Paragraph 815-40-25-19 provides additional guidance on this matter, “If an entity could be required to obtain shareholder approval to increase the entity’s authorized shares to net share or physically settle a contract, share settlement is not controlled by the entity.”

This is an example of how the current accounting rules (the FASB’s Accounting Standards Classification) do not sufficiently contemplate or address the reality of SAFEs in practice.  Technically, at present, the Company does not have enough authorized shares to issue upon conversion of the SAFEs.  However, it is very easy for the Company to increase the number of authorized shares, at will.  Furthermore, the ability to increase the number of authorized shares of the Company is completely under the control of the Company.  The Company’s cofounders own nearly 100% of the Company.  There are no other Board members.  There are no other parties with voting rights.  There are no external lenders holding restrictive covenants.  There are no impediments, whatsoever, to the Company increasing the number of authorized shares by a sufficient amount to issue the required number of shares, upon conversion of the SAFEs. 

Thus, by virtue of the total control of the cofounders, the Company has the ability to authorize and issue a sufficient number of shares to successfully convert the SAFEs into shares of equity. 

Thus, the “spirit of the law” of this requirement is met.

Furthermore, it is important to realize that whether or not the Company ever even issues any shares of preferred stock is completely within the control of the Company.  If the Company chooses not to ever issue preferred stock, the SAFEs will never have an opportunity to be converted into preferred stock; and so, the question of whether or not the Company has a sufficient number of shares of preferred stock to settle the conversion would never even arise.

The minutes from the FASB’s Emerging Issues Task Force’s (“EITF’s”) November 15–16, 2000, meeting, are informative.  These minutes state, in part, “It is not necessary to subtract anticipated voluntary share issuances from the number of authorized but unissued shares because such issuances are, by definition, within the control of the company.”

As has been stated previously, there is nothing to force the Company to ever have a preferred stock financing round, and therefore, there is nothing to force the Company to ever convert the SAFEs into shares of equity.  The decision of whether or not to have a preferred stock financing, and therefore whether or not to convert the SAFEs into shares of equity, is entirely under the control of the Company’s cofounders.  Therefore, the future issuance of shares by the Company, if it happens, is voluntary.

3.2.1.c Limit to Number of Shares to be Issued

To qualify for equity classification, “(the) contract (must contain) an explicit share limit. The contract (must contain) an explicit limit on the number of shares to be delivered in a share settlement.”

Paragraph 840-15-25-26 expounds further: “For certain contracts, the number of shares that could be required to be delivered upon net share settlement is essentially indeterminate.  If the number of shares that could be required to be delivered to net share settle the contract is indeterminate, an entity will be unable to conclude that it has sufficient available authorized and unissued shares and, therefore, net share settlement is not within the control of the entity.”

This is another case in which the accounting standards do not sufficiently comprehend or address the realities of how SAFEs operate in the real world.  Technically, the SAFE contracts do not explicitly limit the number of shares to be issued.  But, of course, the number of shares to be issued is limited. 

The Conversion Price, when the SAFEs are converted into shares, will be calculated as the lesser of:

  1. (Discount Rate) x ((Pre-Money Valuation) / (# of Fully Diluted Outstanding Shares)); or
  2. (Valuation Cap) / (# of Fully Diluted Outstanding Shares).

And the number of shares issued will be:

         ($ Amount Invested by SAFE Investor) / (Conversion Price).

The currently unknown factor, in the above calculations, is, of course, the future Pre-Money Valuation of the Company at the time of the SAFE conversion.  The stated conclusion of this part of the ASC is that, because the number of shares to be issued is not explicitly identified as a fixed number now, the actual number of shares to be issued in the future might be more than the Company has authorized and available to issue at that time, and therefore, net share settlement (a requirement for equity classification) is not within control of the Company.  While this argument may be sound in the case of large, publicly traded companies, which must obtain stockholder approval prior to authorizing or issuing additional shares; it is not valid for a small startup company in which the cofounders of the Company exercise 100% control over all decisions of the Company and can authorize and issue shares at will.

Thus, net share settlement is within control of the Company.  Thus, again the “spirit of the law” of this requirement is satisfied.

Furthermore, it is important to realize that whether or not the Company ever even issues any shares of preferred stock is completely within the control of the Company.  If the Company chooses not to ever issue preferred stock, the SAFEs will never have an opportunity to be converted into preferred stock; and so, the question of whether or not the Company has a sufficient number of shares of preferred stock to settle the conversion would never even arise.

The minutes from the FASB’s Emerging Issues Task Force’s (“EITF’s”) November 15–16, 2000, meeting, are informative.  These minutes state, in part, “It is not necessary to subtract anticipated voluntary share issuances from the number of authorized but unissued shares because such issuances are, by definition, within the control of the company.”

As has been stated previously, there is nothing to force the Company to ever have a preferred stock financing round, and therefore, there is nothing to force the Company to ever convert the SAFEs into shares of equity.  The decision of whether or not to have a preferred stock financing, and therefore whether or not to convert the SAFEs into shares of equity, is entirely under the control of the Company’s cofounders.  Therefore, the future issuance of shares by the Company, if it happens, is voluntary.

3.2.1.d No Cash Payment Required if Entity Fails to File Timely

To qualify for equity classification, “(there must be) no required cash payment if entity fails to timely file. There (must be) no required cash payments to the counterparty in the event the entity fails to make timely filings with the Securities and Exchanges Commission (SEC).”

This requirement is clearly met.  There is no cash payment required based on whether or not the Company files its financial statements timely with the SEC.

3.2.1.e No “Top Off” or “Make Whole” Provision

To qualify for equity classification, “(there must be) no cash-settled top-off or make-whole provisions. There (must be) no cash settled top-off or make-whole provisions.”

This requirement is clearly met.  There are no such provisions.  In fact, SAFE investors face the very real risk of completely losing their entire investments.

3.2.1.f No Contractual Rights Greater than Rights of Holders of Underlying Stock

To qualify for equity classification, “no counterparty rights (may) rank higher than shareholder rights. There (must be) no provisions in the contract that indicate that the counterparty has rights that rank higher than those of a shareholder of the stock underlying the contract.”

This requirement is clearly met.  The “stock underlying the contract” is preferred stock, which has not yet been issued, but it can be concluded with certainty that the rights of the SAFE holders are lesser than the rights of any preferred stockholders.  Moreover, the rights of SAFE holders are even less than the rights of common stockholders.  Effectively, the SAFE holders have no rights at all.  They cannot vote.  They have no representation on the Board of Directors.  The disposition of their investment is completely under the absolute control of the cofounders (and majority stockholders) of the Company.

3.2.1.g No Collateral is Required

To qualify for equity classification, “(there must be) no collateral required. There (must be) no requirement in the contract to post collateral at any point or for any reason.”

This requirement is clearly met.  There is no requirement or the Company to post collateral to protect the position of the SAFE holders.  In fact, the SAFE holders have no position to be protected.  They truly are at risk of losing all of their cash investment.

4.0 ASC 815-15 – “Derivatives and Hedging – Embedded Derivatives”

4.1 Scope Analysis

ASC 815-15-15-2 says, “The guidance in this Subtopic applies only to contracts that do not meet the definition of a derivative instrument in their entirety.”

This description is accurate for SAFEs, so, SAFEs are within the scope of this guidance.

4.2 Accounting Analysis

ASC 815-40-25-39 guides that, “For purposes of evaluating under paragraph 815-15-25-1 whether an embedded derivative indexed to an entity’s own stock would be classified in stockholders’ equity if freestanding, the requirements of paragraphs 815-40-25-7 through 25-35 and 815-40-55-2 through 55-6 do not apply if the hybrid contract is a conventional convertible debt instrument in which the holder may only realize the value of the conversion option by exercising the option and receiving the entire proceeds in a fixed number of shares or the equivalent amount of cash (at the discretion of the issuer).”

SAFEs are not convertible debt, but they do have some characteristics that are similar to convertible debt, so, it is enlightening and helpful to consider ASC 815-10-25-17. 

ASC 815-10-25-17 guides that, “… the terms of convertible preferred stock (other than the conversion option) shall be analyzed to determine whether the preferred stock (and thus the potential host contract) is more akin to an equity instrument or a debt instrument.  A typical cumulative fixed-rate preferred stock that has a mandatory redemption feature is more akin to debt, whereas cumulative participating perpetual preferred stock is more akin to an equity instrument.”

ASC 815-10-25-17 specifically references convertible preferred stock.  Again, SAFEs are not convertible preferred stock, but they have some characteristics that are similar to convertible preferred stock.  So, it is informative and helpful to consider the principles of ASC 815-10-25-17.

Remarkably, in an otherwise very technocratic rules oriented area of accounting (determining whether derivatives should be accounted for as debt or equity), the ASC, in this case, prescribes judgment!  It directs us to “analyze” whether an instrument is “more akin to an equity instrument” or “more akin to a debt instrument”.  This sort of language in the ASC is refreshing.  Our underlying argument, all along, has been that an accurate analysis of SAFEs clearly indicates that they are much more akin to equity than to debt.  The risk-reward characteristics of SAFEs are those of venture equity, not debt.  (See the instruction and conclusion of this paper, and also see previous papers and analysis submitted.) 

5.0 Conclusion

SAFE investors invest cash with the Company, in return for a very uncertain promise that their cash investment may convert to preferred stock in the future only if the Company is successful enough to attract preferred stock investors and the two stockholders of the Company decide to execute a preferred stock round of financing.  There is a very real possibility the SAFEs will never convert into shares of preferred stock and the SAFE holders will never get anything in return for their investment.  But the hope, and the plan, is that the Company will grow and will execute a preferred stock financing; and in that case, the SAFE investors have the possibility of earning from 200% to 400% return on investment when their SAFE investment dollars convert into shares of preferred of stock; and additionally, they have the potential of earning returns much greater than that, if the Company later does an IPO, or gets acquired, and the investors can sell their shares of preferred stock at a greatly increased price.

SAFE holders have no guaranteed payback.  Therefore, their investment cannot be appropriately classified as debt.  Debt classification would be against the most fundamental principles of accounting and financial reporting.  We must not abandon first principles and allow for SAFEs to be classified as debt, simply because the accounting rules have not caught up to the reality of SAFEs in practice.

The risk-reward profile of SAFE investments is that of venture equity in an early-stage startup company, and certainly not that of debt (which includes a promise of a specified payoff with a specified timeframe).  The goal, of course, of the SAFE investors, and the expressed plan of the Company, is that SAFE investments will convert into preferred stock when (and if) the Company executes a preferred stock financing.  But the SAFE holders face two very real risks that could foil their plans:

  • The Company could fail and never execute a preferred stock financing; and
  • The Company could become profitable and self-sustaining and choose never to execute a preferred stock financing.

Under both of the above scenarios, the SAFE investors would be at risk of completely losing their investments, with the Company having no obligation to repay the SAFE investors their contributed cash.  (One SAFE investor in the Company can get his cash back, if, after four years, the Company has not executed a preferred stock financing.  But even that investor is still subject to the first risk listed above, that the Company may fail, and if that happens within four years, that SAFE investor too would lose his investment with nothing to show for it.

Thus, SAFEs should be classified as equity and not debt.

The legal substance of Simple Agreements for Future Equity (SAFEs) is that the investor contributes cash to the Company in exchange for the uncertain promise of future equity.  The SAFE investor gets absolutely nothing now in exchange for his or her contributed capital.  Thus, SAFEs should be classified as additional paid-in capital within equity.  There really is no other appropriate classification on the balance sheet for SAFEs, other than additional paid-in capital.