Seed-Stage Startup Financing Innovation
SAFEs (Simple Agreements for Future Equity) are old news in the fast-moving realm of startup companies and seed-stage venture capital. But in the buttoned-down world of accounting rules and SEC regulations, SAFEs are very much on the cutting edge of problematic issues. The accounting rules have not been updated sufficiently to cover SAFEs, and they need to be.
2013 – Y Combinator Introduces the SAFE
Y Combinator partner and attorney, Carolynn Levy, created the SAFE instrument in 2013 as a replacement for the previously most popular form of seed-stage startup financing, the convertible note. Levy designed the SAFE instrument to solve two problems inherent in convertible notes: (i) a fixed maturity date; and (ii) accrued interest.
Due to technicalities of state law, as well as investor sentiment, terms of convertible notes tend to be relatively short – typically no more than two years. If the conversion mechanism (typically a priced financing round of preferred stock) has not happened by the maturity date, convertible notes must be paid off, at worst, or renegotiated, at best. Thus, maturity dates create adverse consequences for early-stage startup companies by forcing them to repay debt before they are ready, or causing them to incur administrative cost to renegotiate and/or “repaper” convertible notes when they become due.
The other major problem with convertible notes is that they include accrued interest. This accrued interest is added to the principal of the convertible debt, and over time, it can amount to a sizeable cost to startups in terms of repayment obligation or equity dilution (when the convertible debt is converted into equity).
Levy’s innovation, the SAFE, solves both of these problems for seed-stage startup companies, thus making seed-stage financing much more “startup friendly.” You can read more about it in this TechCrunch article from December 2013.
In July 2014, 500 Startups introduced its version of the SAFE, which it named the KISS (Keep It Simple Security).
In Silicon Valley, SAFEs are Equity (not Debt!)
The introduction of the SAFE by Y Combinator shines as an excellent example of what Silicon Valley does best – innovate to make business cleaner, simpler, faster, better and more accessible to startup founders. Startup founders and their fellow managers are extremely busy people, and their working time is most valuably spent developing their technology, building their teams and serving their customers – not on administrative burdens like renegotiating convertible debt agreements with imminent maturity dates bearing down on them. The SAFE is a simple, yet brilliant, innovation that protects startup founders from an unnecessary administrative burden and enables them to focus on building their businesses.
And in Silicon Valley, the accounting for SAFEs also is simple – SAFEs are equity contributions of early investors in seed-stage startup companies. SAFEs are not debt. The very idea of anyone even debating about them possibly being debt is strange and silly to finance professionals working in Silicon Valley. SAFEs were created for the express purpose of avoiding the trappings of debt! (Of course, some so-called “SAFEs” contain a mandatory repayment obligation after a specified amount of time. Such “SAFEs” are SAFEs in name only, of course. In essence, instruments with such clauses are nothing more than convertible debt, under a different name.)
SAFEs are working beautifully well for many Silicon Valley startups.
To be sure, not everyone is happy with them. Specifically, SAFEs have increased the downside risk to seed-stage investors. In addition to the obvious and well-known risk of business failure, now SAFE investors also face the unexpected risk of successful startup companies achieving self-sufficiency and never doing a priced financing round (because they don’t need it) and therefore never being compelled to convert SAFE funds to equity nor to repay the contributed cash. This is a potential negative outcome that does not happen most of the time, but does occur frequently enough to have become a sore spot with some seed-stage investors.
Overall, however, SAFEs have been a great contribution to the startup ecosystem and have tilted the balance of power, to a significant degree, away from seed-stage investors, in favor of startup founders.
But an unexpected complication has arisen. With the advent of crowdfunding (Regulation CF) and mini-IPOs (Regulation A+), some small startup companies now are being required to file financial statements with the United States Securities and Exchange Commission (the “SEC”).
The contrast between Y Combinator easing administrative burdens on small startup companies and the SEC laying incredible administrative burdens on them could not be more extreme. If startup accelerators, like Y Combinator, are bullet trains speeding technology-based startups to business success, the SEC is a psychedelic van from the 70s, broken down on the side of the highway, impeding progress.
Enter the Pencil-Headed Thinking of the SEC
Nobody ever accused the SEC staff of exhibiting common sense. If anyone were to make that charge against them, I’m afraid there would not be enough evidence to indict.
The SEC staff is a strange group of people who seem to actually believe that every question of accounting can be resolved with iron clad, inflexible rules to be prescribed absent from and in authority over any and all professional judgment. They are the antithesis of the global push for a more principles-based system of accounting regulation. (In fact, they’re probably the main reason for the global push for a more principles-based system of accounting regulation.)
The SEC’s response to SAFEs is a fiasco caused by their attempt to apply existing accounting rules to a new financing innovation, for which no proper accounting rules yet exist. They’re trying to force a proverbial round peg in a square hole, and it’s a mess.
The SEC has not taken any public position regarding SAFEs, except to warn “retail investors” to “be cautious of” them. You can read about that in this SEC Investor Bulletin from May 2017. Privately, however, the SEC is forcing Reg CF and Reg A+ filers with SAFEs to report them in the liabilities section of the companies’ balance sheets. This is wrong on so many levels.
First of all, reporting SAFEs as liabilities has the effect of causing these companies’ reported equity to be negative. This causes real harm to companies who need to be licensed by various state licensing agencies, which tend to require positive reported equity. Additionally, liability classification gives the impression that companies have a repayment obligation. This is not accurate, and it gives a false assurance to investors. Liability classification gives a false sense of security to investors that is misplaced.
Adding insult to injury, the SEC is privately requiring that SAFEs be accounted for as debt derivatives. This forced treatment introduced extreme accounting complexity. It requires startup companies to estimate the fair market value (not the face amount) of SAFE instruments and accrue periodic expenses for the increase in fair market value of SAFEs over time. In a word, this is complete nonsense. And the SEC staff is mandating all of this even though the SEC has admitted publicly that SAFEs are “different from” convertible notes and that SAFEs do not represent any legal obligation of a company to repay the contributed amounts to investors.
Needed: FASB Action
We need the Financial Accounting Standards Board (the “FASB”) to step in. The FASB is the professional body that promulgates the official accounting and financial reporting rules in the United States, referred to as generally accepted accounting principles (U.S. “GAAP”).
Unlike the SEC, the FASB is composed of the best and the brightest of the U.S. accounting profession. They have the breadth and depth of knowledge, expertise and experience to make sound judgments regarding new accounting rules. We need the FASB to codify new accounting rules for SAFEs so that the SEC will have a paint-by-numbers scheme to follow.
The reason everyone understands how to account for and report mandatorily redeemable preferred stock is because the FASB has written rules, based on core principles, that govern the accounting and reporting of them. The reason there is universal agreement about the accounting for and reporting of nonredeemable convertible preferred stock is that the FASB has codified rules on the subject. The reason there is general consensus regarding the accounting for and reporting of derivative instruments, even though they are complex, is that the FASB has provided guidance. We need the FASB to issue the same kind of guidance on the accounting for and reporting of SAFEs.
We need the FASB to rule on the matter, and the ruling needs to be that SAFEs (standard SAFEs with no guaranteed repayment obligation) should be accounted for and reported as additional paid-in capital, part of permanent equity. The case for equity treatment follows.
What are SAFEs Anyway?
SAFEs are financing instruments, whereby angel or seed-stage venture investors contribute cash to startup companies, in exchange for the possibility of their investment being converted into future equity – but only if certain future events occur. As a form of financing, the funds from these agreements must be classified as either: (i) debt; (ii) equity; or (iii) something in between – so called “mezzanine” or temporary equity.
Current U.S. GAAP does not specifically address SAFEs. The FASB has not issued any authoritative guidance related specifically to SAFEs. Thus, in determining the appropriate accounting for SAFEs, it is imperative to do the following:
- Understand the essential nature of SAFEs; and
- Draw upon principles from the authoritative GAAP guidance for other instruments, which although different in important aspects, share some similarities with SAFEs.
In applying the above requirements, it is important to note that in some respects, SAFEs share similar features with each of the following instruments, but at the same time, SAFEs are different from each of them in fundamentally important ways: convertible debt; call options; and convertible preferred stock. Because SAFEs are similar to each of these in some ways, but essentially different in other, very important respects, it is necessary to draw out principles that apply to specific features of various different instruments, and apply such principles to various features of SAFEs, without attempting to apply rules in an automatic, nonjudgmental way, since such rules do not yet exist for SAFEs.
In their conversion features, SAFEs are very similar to convertible debt. But SAFEs do not contain important debt features such as, accrued interest, fixed maturity, nor a repayment obligation. SAFEs are in some ways similar to call options – the investor has a chance to acquire shares in the future. But, unlike call options, there is not future exercise price - the full price has already been paid. SAFEs are designed and intended to convert into shares of preferred stock, so in that sense, they are somewhat similar to preferred stock. But SAFEs are not preferred stock – at least not yet – and the holders of SAFEs do not own any shares of preferred stock (nor Common Stock) until and unless the SAFEs convert.
In the sections below, the key components of the standard Y Combinator SAFE are described, and the relevant sections of current U.S. GAAP accounting are analyzed.
Equity Financing Event
This is Section 1(a). This is front and center. This is the expected outcome in the normal course. It is the understanding and intent of both seed-stage investors and seed-stage startup founders that, in the normal course, funds invested under SAFE instruments will be converted to shares of preferred stock in a future, hoped for, anticipated priced financing in which newly created shares of preferred stock are issued. This is the hope. This is the intent. But this is never guaranteed. Seed-stage investors in SAFEs are taking a big risk, in hope of big returns. This is a high-beta proposition.
Section 1(a) of the standard Y Combinator SAFE reads:
“If there is an Equity Financing before the termination of this Safe, on the initial closing of such Equity Financing, this Safe will automatically convert into the number of shares of Safe Preferred Stock equal to the Purchase Amount divided by the Conversion Price."
In their conversion feature, SAFEs are very similar to convertible debt instruments. However, SAFEs were designed for the explicit purpose of avoiding the debt characteristics of convertible notes, namely, accrued interest, a defined maturity date, and a repayment obligation upon maturity.
The purpose of SAFEs (as well as convertible debt) is to allow seed-stage investors to invest in early-stage startup companies without the investors having to assign a value to the investment and without the companies having to sell priced securities. Such early investors can simply contribute cash to startup companies with the stipulation that those funds will convert into, or purchase, shares of preferred stock, later, when, and if, the first priced preferred stock round of financing occurs. The number of shares each SAFE investor receives will be calculated based on the conversion price, which will be equal to the lesser of:
- The price per share paid by the new preferred stock investors multiplied by the Discount Rate (as defined in the SAFE agreement); and
- The Valuation Cap (as defined in the SAFE agreement) divided by the number of fully diluted shares of Common Stock and common stock equivalents (potential shares, as if converted) outstanding immediately prior to conversion.
It is important to note that, before the SAFE converts to preferred stock, the SAFE investors do not own any shares of stock (neither preferred nor Common). According to the terms of the SAFEs, it is possible that successful startup companies may continue to operate indefinitely without ever executing a priced equity financing round and that, therefore, in such a situation, the SAFEs may never convert into shares of equity. In that scenario, SAFE investors may simply completely lose their investment, with nothing to show for it. This possible scenario of SAFE investors completely losing their investments with nothing in exchange is not merely hypothetical. Actual cases of this have occurred. Because SAFEs are not debt instruments, the companies do not have an absolute obligation to repay the contributed cash. And SAFEs are convertible into shares of preferred stock only in the event of a preferred stock financing, as specifically prescribed in the SAFE agreements.
A Liquidity Event is defined as a Change of Control or Initial Public Offering – in other words, a corporate strategic transaction in which the majority of the voting power of a company changes hands. Note that such a Liquidity Event is also commonly referred to as an “exit” – either an IPO or an M&A transaction – and that such an exit is the precise financial goal of startup company investors.
If such a Liquidity Event, or exit, occurs prior to the SAFEs converting into shares of Preferred Stock, a startup company’s SAFE investors have the right to receive the greater of:
- Their cash invested; or
- The amounts payable on the number of shares of Common Stock into which their SAFE instruments are convertible.
This alternative outcome is described in Section 1(b) of the standard Y Combinator SAFE:
“If there is a Liquidity Event before the termination of this Safe, this Safe will automatically be entitled to receive a portion of Proceeds, due and payable to the Investor immediately prior to, or concurrent with, the consummation of such Liquidity Event, equal to the greater of (i) the Purchase Amount (the ‘Cash-Out Amount’) or (ii) the amount payable on the number of shares of Common Stock equal to the Purchase Amount divided by the Liquidity Price (the ‘Conversion Amount’).”
Note that this scenario of a cash payout of the greater of the amount invested or the value of Common Shares into which the SAFE is entitled to convert is available to the SAFE investor only in the case of a Liquidity Event (a merger or an IPO). Note also that early-stage startup companies, which have not yet had a priced preferred stock financing round (and hence, the SAFEs are still outstanding) are completely controlled by a small group of cofounders, who have the ability to choose whether or not to accept any purchase offer and also have the ability to decide whether or not to pursue an IPO. Thus, SAFE investors have no control over the outcome of their SAFE investments. Their outcome is strictly determined by the actions and decisions of the companies’ cofounders.
If a startup company’s cofounders have an opportunity for a good exit – i.e., a highly profitable merger or IPO – they will take it, and the SAFE investors will receive an excellent payoff – that of a holder of Common Stock. If, on the other hand, things do not go well for the company, the cofounders have the ability to simply run the company into the ground and expend all the cash. The SAFE investors have no mechanism to prevent such action by the cofounders. In that case, the SAFE investors would receive nothing. Thus, the risk-reward profile of SAFE investors is that of equity investors in an early-stage startup company.
SAFE investors in startup companies have no power over their own destiny. They have no Board seats and no votes. Their position is strictly passive. Their outcome is strictly determined by the performance of the company and the decisions of the cofounders.
A Dissolution Event essentially is the ceasing of operations and shutting down of a company. In the case of a Dissolution Event, SAFE investors are entitled to receive back their cash invested – if there is any remaining cash to be paid out.
This alternative outcome is described in Section 1(c) of the Y Combinator SAFE.
“If there is a Dissolution Event before the termination of this Safe, the Investor will automatically be entitled to receive a portion of Proceeds equal to the Cash-Out Amount, due and payable to the Investor immediately prior to the consummation of the Dissolution Event.”
While this “right” of SAFE investors to receive their money back, if things go badly for a startup company, sounds good on paper, in reality, SAFE holders have no ability to enforce this contractual provision. The reality is that the cofounders can run the company into the ground and spend all the money, leaving nothing for the SAFE investors, and there is absolutely nothing the SAFE holders can do to prevent that. SAFE investors have no Board seats and no voting power and are completely subject to the will of the cofounders of the Company as to whether they ever have an opportunity to receive any of their cash investment back.
Relevant Accounting Guidance and Application to SAFEs – Accounting Standards Codification (“ASC”)
ASC 480 – “Distinguishing Liabilities from Equity”
ASC 480-10-25-4 prescribes:
“A mandatorily redeemable financial instrument shall be classified as a liability unless the redemption is required to occur only upon the liquidation or termination of the reporting entity.”
Mandatory redemption refers to a specified payback schedule, normally with accrued interest, if the financial instrument has not previously converted into equity. Mandatory redemption occurs most commonly in the case of mandatorily redeemable preferred stock. SAFEs are not mandatorily redeemable. (Note that some investors have in some companies have required mandatory redemption features be written into their “SAFEs”. But in those cases, such an instrument is a “SAFE” in name only – in reality, it is debt.)
This guidance from the FASB clearly says that, even for mandatory redemptions, if they are “required to occur only upon the liquidation or termination of the (company),” they should not be classified as liabilities.
It is enlightening to consider the aspect of control of a startup company and whether or not the SAFE holders could ever force a cash payment, or redemption, of their SAFEs without the consent of the current stockholders of the company. The clear answer is that no, the SAFE holders cold never force such a redemption. The cofounders typically own 100%, or nearly 100%, of the outstanding equity shares of the company, and therefore, they exercise complete control of the company, and have the ability to maintain complete control. The SAFE holders could never force redemption of their SAFEs. The reality of total control of startup companies held by the cofounders strongly indicates that SAFEs should be accounted for as equity and not debt.
ASC 480-10-25-7 further clarifies, “If a financial instrument will be redeemed only upon the occurrence of a conditional event, redemption of that instrument is conditional and, therefore, the instrument does not meet the definition of mandatorily redeemable financial instrument …”
Thus, the FASB has gone out of its way to make it doubly clear that convertible financial instruments, with characteristics like the Company’s SAFEs, are not mandatorily redeemable, and thus this condition for debt treatment is not triggered.
ASC 480-10-25-14 states in part, “A financial instrument… that the issuer must or may settle by issuing a variable number of its equity shares shall be classified as a liability… if, at inception, the monetary value of the obligation is based solely or predominantly on… a fixed monetary amount known at inception (for example, a payable settleable with a variable number of the issuer’s equity shares).”
At first glance, this paragraph of the ASC seems to indicate liability accounting for SAFEs, and thus seems inherently contradictory to and inconsistent with paragraphs 480-10-25-4 and 480-10-25-7. However, upon further investigation, it becomes clear that SAFEs are very different from the type of transaction contemplated in ASC 480-10-25-14.
The definition of “monetary value” provided by the FASB is “What the fair value of the cash, shares, or other instruments that a financial instrument obligates the issuer to convey to the holder would be at the settlement date under specified market conditions.” No such monetary value SAFES at settlement (conversion) date can be determined until some yet to be determined date in the future.
Furthermore, paragraph 480-10-25-14 provides an illustrative example of the scope of this paragraph: a previously existing “payable”. This paragraph is contemplating a liability obligation – a “payable” – that the Company owes and negotiates to settle by delivering shares to the creditor, with enough shares being delivered to satisfy the debt, based on the market value of the shares on the date of settlement. This is not at all the nature of the transaction with the SAFEs.
With SAFEs, early investors are investing in a startup company, in exchange for the anticipated potential of future equity, namely preferred stock (which doesn’t even exist yet) at some undefined date in the future, when the first priced preferred stock financing round occurs. This is not a transaction of a creditor, but rather that of an early equity investor.
Furthermore, the paragraphs ASC 480-10-25-4 and ASC 480-10-25-7 (discussed above) more accurately and directly relate to SAFEs, and both of them clearly and strongly indicate that SAFEs should not be accounted for as liabilities.
ASC 815-40 – “Derivatives and Hedging – Contracts in Entity’s Own Equity”
Detailed study of ASC 815-40 makes clear that current authoritative GAAP does not adequately address SAFEs. The FASB simply has not yet updated GAAP to provide sufficient guidance on how to account for SAFEs. The purpose of this article is to request the FASB to provide such guidance.
In the absence of guidance on accounting for SAFEs from the FASB, the SEC has taken a very legalistic, rules-based approach to trying deal with SAFEs. The SEC staff’s approach demonstrates a lack of understanding of the essential nature of SAFEs. While the SEC has not taken any official position on accounting for SAFEs, privately, the SEC staff are forcing small companies that raise money under Regulation CF or Regulation A+, via SAFEs, to classify those SAFES as liabilities. The SEC’s current practice on this issue is incorrect and misguided, as it misrepresents the true essence of what SAFEs actually are – a high risk early investment in startup companies. On the ground in Silicon Valley, where SAFEs were created, the SEC’s current practice regarding SAFEs is seen as unreasonable, as it distorts and misrepresents the true nature of SAFEs. Practitioners in Silicon Valley, working with startup companies on a daily basis, understand that SAFEs are early equity investments in startups.
The analysis of ASC 815-40 highlights the need for the FASB to issue authoritative guidance regarding accounting for and reporting of SAFEs, and that guidance should be that SAFEs are additional paid-in capital, part of permanent equity.
ASC 815-40 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, an 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:
- Evaluate the instrument’s contingent exercise provision, if any;
- 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:
- The fair value of a fixed number of the entity’s equity shares; and
- 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 then 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:
- Strike price of the instrument;
- (b-g) are irrelevant; and
- The ability to maintain a standard hedge position in the underlying shares.
With SAFEs, the key variables that will affect the settlement amount are the share price of the future preferred stock, as negotiated in the future preferred stock financing round (if and when it happens) and the Conversion Price, which will depend both on the negotiated Valuation Cap in the SAFE agreement and the number of fully diluted outstanding shares.
Thus, ASC 815-40 contains some principles relevant to SAFEs.
ASC 815-40 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:
- Contracts that require net cash settlement are assets or liabilities; and
- 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 well understood purpose of SAFE investments is for them to convert into shares of preferred stock at some point in the future, when a preferred stock round of financing occurs. This fact provides a strong compass setting 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:
- Contracts shall be initially classified as either assets or liabilities in both of the following situations:
- 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)
- Contracts that give the counterparty a choice of net cash settlement or settlement in shares (physical settlement or net share settlement).
- Contracts shall be initially classified as equity in both of the following situations:
- Contracts that require physical settlement or net share settlement
- 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.”
ASC 815-40 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:
- Settlement permitted in unregistered shares. The contract permits the entity to settle in unregistered shares.
- 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.
- Contract contains an explicit share limit. The contract contains an explicit limit on the number of shares to be delivered in a share settlement.
- 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).
- No cash-settled top-off or make-whole provisions. There are no cash settled top-off or make-whole provisions.
- 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.
- 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 stipulations are analyzed, in turn, below.
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. Unregistered shares of preferred stock are normally issued to SAFE investors upon conversion. Registration of the preferred shares with the SEC is not required, or even contemplated, as part of the standard SAFE agreement.
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 Codification or “ASC”) do not sufficiently contemplate or address the reality of SAFEs in practice.
Technically, before SAFEs convert, startup companies do not have enough authorized shares to issue upon conversion of the SAFEs. However, it is very easy for seed-stage startup companies to increase the number of authorized shares, at will. The ability to increase the number of authorized shares of startup companies is completely under the control of the cofounders, who typically hold 100%, or nearly 100%, of the outstanding equity shares of the companies. Typically, for early-stage startups with SAFEs, there are no Board members other than the cofounders. There are no other parties with voting rights. There are no external lenders holding restrictive covenants. There are no impediments, whatsoever, to startup companies increasing the number of authorized shares by a sufficient amount to issue the required number of shares, upon conversion of SAFEs. By virtue of the total control of the cofounders, startup companies have the ability to authorize and issue a sufficient number of shares to successfully convert the SAFEs into shares of equity. Thus, in practice and actual outcome, this requirement is met.
Furthermore, it is important to realize that whether or not a startup company ever even issues any shares of preferred stock is completely within the control of the cofounders of the company. If the cofounders of a startup company choose never to issue preferred stock, the SAFEs will never 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 be moot.
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.”
SAFE holders have no mechanism ever to force a preferred stock financing round and resulting conversion of their invested funds into shares of preferred stock. SAFE holders have no ability to force startup companies in which they invest to do anything. The decision of whether or not ever 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 entirely voluntary on the part of the startup companies.
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 current accounting standards do not sufficiently comprehend or address the realities of how SAFEs operate.
Technically, SAFE contracts do not explicitly limit the number of shares to be issued. But, of course, the number of shares to be issued is effectively limited by the SAFE agreement. The Conversion Price, when SAFEs are converted into shares, will be calculated as the lesser of:
- (Discount Rate, as Defined in the SAFE Agreement) x (Share Price of Newly Issued Preferred Stock); or
- (Valuation Cap, as Defined in the SAFE Agreement) / (# of Fully Diluted Outstanding Shares).
And the number of shares issued will be:
($ Amount Contributed by SAFE Investor) / (Conversion Price).
The currently unknown factors in the above calculations, are, of course, the share price of future preferred stock and the number of fully diluted outstanding shares at the time of conversion of the SAFEs.
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 is sound in the case of large, publicly traded companies, which must obtain approval from a large number of Common Stockholders prior to authorizing or issuing additional shares, it is not valid for small startup companies in which the cofounders exercise absolute control over all decisions and can authorize and issue shares at will.
The minutes from the FASB’s Emerging Issues Task Force’s (“EITF’s”) November 15–16, 2000 meeting are illuminating. 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.”
SAFE holders have no mechanism ever to compel a startup company to issue preferred stock, and therefore, there is nothing to force a startup company ever to convert SAFEs into shares of equity. The decision of whether or not to execute a preferred stock financing, and therefore whether or not to convert SAFEs into shares of equity, is entirely under the control of a startup company’s cofounders. Therefore, the future issuance of shares by such a company, if it happens, is entirely voluntary on the part of the company. If a startup company chooses to issue preferred stock, it can authorize sufficient shares at will. Thus, net share settlement is within control of such a startup company. In practice, this requirement is met.
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. Most startups don’t file with the SEC, but even for the ones who do, SAFE holders are not entitled to any cash payments if the companies are late filing their financial statements with the SEC.
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 SAFE contracts. In fact, SAFE investors face the very real risk of completely losing their entire investments, with nothing in return.
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 indicates 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 authorized nor issued, and so does not yet even exist. But the effective rights of SAFE holders are less than the rights of holders of Common Stock. Effectively, SAFE holders have no rights at all. Even though the standard SAFE agreement grants certain rights to holders of SAFEs, SAFE holders have no ability to enforce any of their rights. SAFE holders cannot vote. SAFE holders have no representation on companies’ Boards of Directors. The disposition of their investment is completely under the absolute control of the cofounders, who also are the majority stockholders, of a startup company.
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. SAFE agreements do not have any requirement for companies to post collateral to protect the position of SAFE holders. In fact, SAFE holders have no position to be protected. They truly are at risk of losing all of their cash investment. The position of SAFE holders is very similar to the position of Common Stockholders, but SAFE holders’ position is even more vulnerable than Common Stockholders’ position, because the cofounders, who also are Common Stockholders, of startup companies exercise complete control of the companies. SAFE holders have no Board seats. SAFE holders have no votes. SAFE holders have no control and no protection against the absolute control of the cofounders.
ASC 815-15 – “Derivatives and Hedging – Embedded Derivatives”
ASC 815-15 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, this guidance is relevant for SAFEs.
ASC 815-15 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 informative to consider this guidance.
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. Of course, SAFEs are not convertible preferred stock, but they have some characteristics that are similar to convertible preferred stock. So, it is enlightening 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 the exercise of 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, and it bolsters our argument that SAFEs should be accounted for as equity and not debt. The essential nature of SAFEs is that they are much more akin to equity than to debt. The risk-reward characteristics of SAFEs are those of venture equity, not debt.
ASC 718-10-25-8 states in part: “… a call option written on an instrument that is not classified as a liability… also shall be classified as equity... “
SAFEs are not call options, but they are similar to call options in that they convey a potential right to future equity. Because the contingent right is to future equity (not debt), SAFEs should be classified as equity, within additional paid-in capital, just as call options are.
S99-3A – SEC Staff Announcement: Classification and Measurement of Redeemable Securities
In section 2, the SEC Staff says in part: “ASR 268 requires preferred securities that are redeemable for cash or other assets to be classified outside of permanent equity if they are redeemable (1) at a fixed or determinable price on a fixed or determinable date, (2) at the option of holder, or (3) upon the occurrence of an event that is not solely within the control of the issuer… “
As already described in previous sections, the Company’s SAFEs are:
- not redeemable at a fixed or determinable price on a fixed or determinable date;
- not redeemable at the option of the holder; and
- only redeemable in the event of a Liquidity Event (a change of ownership), and the occurrence of that event is solely with in the control of the two cofounders of the Company.
Conclusion - SAFEs are Additional Paid-in Capital in Equity - We Need the FASB to Act
A SAFE investor contributes cash to a startup company in return for a very uncertain, contingent, possible outcome of his or her cash investment converting to preferred stock in the future only if the startup company is successful enough to attract future preferred stock investors and the cofounders of the company choose to execute a preferred stock round of financing. (This is strictly their choice.) However, there is a very real possibility that SAFEs will never convert into shares of preferred stock, and thus, the SAFE holders may completely lose their investment and never receive anything in return.
The hope of a SAFE Investor is that the startup company in which he or she invests will grow and will execute a priced preferred stock financing. In that case, the investor has the possibility of earning a return of several times his or her investment when the SAFE investment dollars convert into shares of preferred of stock. Furthermore, the investor has the potential of earning returns much greater than that, if the company later does an IPO, or gets acquired, and the investor can sell his or her shares of preferred stock at a greatly increased price. In such situations, SAFE investors have the potential of realizing a return on their investment of 100x or more.
On the other hand, 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. It would be misleading to investors and harmful to companies. 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 not that of debt (which includes a promise of a specified payoff within a specified timeframe). The objective, of course, of SAFE investors is for their SAFE investments to convert into preferred stock when, and if, the startup companies in which they invest execute preferred stock financings. But the SAFE holders face two very real risks that can, and sometimes do, prevent their objective from ever being realized:
- the startup company to which a SAFE investor contributes cash could fail and go out of business; or
- the startup company to which a SAFE investor contributes cash could become profitable and self-sustaining, and in that case, the cofounders of the company could choose never to execute a preferred stock financing.
In both of the above scenarios, the SAFE investors will lose their contributed cash and will receive nothing in return. Thus, the risk-reward profile of SAFE investors is that of early equity investors in a startup company, and the SAFEs should be classified as equity, not debt.
The legal substance of SAFEs is that the investor contributes cash to startup company in exchange for the uncertain hope of receiving future equity – equity shares that do not yet exist. The SAFE investor gets absolutely nothing now in exchange for his or her contributed capital – no Board Seat, no voting power – nothing but the uncertain possibility of future equity. The SAFE Investor faces substantial risk of never receiving anything for his or her investment and instead, completely losing his or her investment, with nothing in return. Thus, debt classification for SAFEs is inappropriate. SAFEs should be classified as additional paid-in capital within permanent equity. There is no other appropriate classification on the balance sheet for SAFEs.
(Caveat: The arguments and positions of this article apply to the standard Y Combinator SAFE instrument. In some situations, some investors have successfully negotiated mandatory redemption, or payback, into their “SAFE” contracts. Those arrangements are not SAFEs. They are “SAFEs” in name only. In fact, contracts altered in such a way are convertible debt agreements.)