We are currently helping to represent a client before the United Sates Securities Exchange Commission (“SEC”) in a case that has broad ramifications for startup companies and investors, especially those involved in crowdfunding under Regulation A.
Investment instruments known as Simple Agreements for Future Equity (“SAFEs”) have garnered tremendous attention from the SEC in the past few months, as evidenced by two SEC Commissioners addressing them in public speeches in February 2017 and May 2017 and an Investor Bulletin published by the SEC in May 2017. (Wow! That’s a lot!) The consistent concern enunciated by the SEC is the relative high degree of risk SAFEs embody (in contrast to their name), especially for individual investors engaging in crowdfunding (as opposed to professional venture capital, or “VC”, firms).
Concurrently, our client is the very first company, with a material amount of SAFE financing, to be required to register audited financial statements with the SEC. We have classified the SAFE financing as additional paid-in capital, within equity, to appropriately represent the relative high risk to the investors. This is an important issue for many startup companies and investors. The SEC needs to get this right.
Accounting for SAFEs is a cutting edge new topic for the SEC. Typically, SAFES exist only in the realm of very early-stage startup companies, traditionally much too small and early-stage to be SEC registrants. However, with the amendments to Regulation A in 2015, some small startup companies with outstanding SAFEs, such as our client, are now filing their financial statements with the SEC.
Origin of SAFEs – Y Combinator – 2013
SAFEs were invented by Y Combinator in 2013 for the specific purpose of replacing convertible notes as instruments for seed investors to invest in early-stage startup companies. SAFES were created to specifically avoid the debt features and repayment obligation of convertible notes. Paul Graham, cofounder of Y Combinator, explained this in an article on Y Combinator’s web site, entitled “Announcing the Safe, a Replacement for Convertible Notes” on December 6, 2013.
“The disadvantage of convertible debt is that although it’s only nominally debt, the law cares what things are nominally, and there are all sorts of regulations about debt. There has to be a term, which in California can’t be too long, and there has to be an interest rate not too far from market rates. The interest on convertible notes makes conversion complicated, and the fact that the debt has a fixed term causes extra work for both parties when it has to be extended.
“A safe is like a convertible note in that the investor buys not stock itself but the right to buy stock in an equity round when it occurs. A safe can have a valuation cap, or be uncapped, just like a note. But what the investor buys is not debt, but something more like a warrant. So there is no need to fix a term or decide on an interest rate.”
Mr. Graham specifically mentions the avoidance of the debt features of a fixed term and accrued interest as important benefits of SAFEs. Mr. Graham also describes the essence of what a SAFE is: “the right to buy stock in an equity round when it occurs… not debt, but something more like a warrant.”
In an article published by TechCrunch on December 6, 2013, entitled, “Y Combinator Introduces Safe, Its Alternative To Convertible Notes”, Carolynn Levy, the lawyer at Y Combinator who personally created the SAFE instrument, explains that she created the SAFE in order to avoid the debt characteristics of convertible notes.
“The two main problems that Safe seeks to solve are the issues of dealing with accrued interest and maturity dates. On the latter end, maturity dates on convertible notes tend to be one year, since they’re issued as short-term debt. But a year comes up fast, and that can be a distraction and a hassle for startups.
“The other issue Safe seeks to do away with is accrued interest on the convertible debt they issue. While it’s mostly just a hassle for startups to figure out how much interest they have due upon conversion, Levy says occasionally there are investors who ask for a high interest rate. Instead of treating their investment like a short-term loan, moving to Safe will ensure that all investors are really in it for the equity upon conversion.
“‘In the securities world, there’s debt and there’s equity,’ Y Combinator partner Carolynn Levy told me. ‘But if everyone wants to own equity in a company, why would you use debt as an investment instrument?’”
The former Wilson Sonsini lawyer who wrote the first SAFE document says she did so specifically to avoid debt. Ms. Levy refers to SAFEs as equity instruments. To account for SAFEs as debt, when the lawyer who wrote SAFEs is on public record stating explicitly that they are not debt, would be imprudent, to say the least.
High Level Scrutiny of SAFEs by SEC Commissioners as a Public Policy Concern
SEC Commissioner Kara M. Stein
In a public statement issued on February 28, 2017, SEC Commissioner Kara M. Stein raised concerns about the riskiness of SAFEs and whether or not they are appropriate for “retail investors”. Her comments were published by the SEC in an article entitled, "SEC-NYU Dialogue on Securities Market Regulation: U.S. Securities-Based Crowdfunding - Closing Remarks". An extract of her comments is below.
“Another interesting observation from today’s program centers on the types of securities many retail investors are receiving in exchange for their crowdfunding investment. Thirty-six percent of crowdfunding offers were equity. The second most common security offered, at 26%, were simple agreements for future equity or ‘SAFE’ securities. These so-called SAFE securities are contractual derivatives. The issuer promises to give the investor stock upon the occurrence of a contingent future event. The event is typically linked to a subsequent valuation event, such as securing an additional round of financing, a company sale, or an initial public offering. However, many small and emerging businesses will never attain the subsequent valuation event. As a result, a retail investor is left with little more than the paper on which the contract is written. SAFEs arguably provide different rights and restrictions and more risk than what retail investors may typically expect. Should we be looking more closely at these securities particularly for retail investors?”
Commissioner Stein states that SAFEs are derivatives. She also says that SAFEs carry “more risk than what retail investors may typically expect.” In context, “what retail investors may typically expect” refers to common stock, because that is the type of security issued most often to retail investors through crowdfunding sites. Thus, Commissioner Stein is saying that SAFEs carry more risk than common stock, likely because the future right to receive equity is contingent upon future triggering events, which may or may not occur. Debt, on the other hand, conveys a definite, non-contingent right to receive a certain payoff. It follows that SAFEs are not debt, as debt carries less risk than common stock.
SEC Commissioner Michael S. Piwowar
SEC Commissioner Michael S. Piwowar also discussed SAFEs in a speech he made on May 9, 2017. Commissioner’s Piwowar’s speech is recorded in an article on the SEC web site entitled, “Opening Remarks at 2017 SEC/NASAA Annual Section 19(d) Conference”.
“In Regulation Crowdfunding, one concerning development that we are monitoring is the use of a new startup-financing instrument – the so-called ‘SAFE’ – in offerings that are intended for a broad, mostly retail base of investors. A SAFE, which stands for a ‘simple agreement for future equity,’ is an agreement between an investor and a company in which the company generally promises to give the investor a future equity stake in the company if certain triggering events occur.
“Although these securities have been used in some Regulation Crowdfunding offerings, they are not securities with which many retail investors are well acquainted. An investor only receives an equity stake in a SAFE company if the specific terms of the security are met. If the terms are not met, the investor is left with nothing. As an additional element of risk, the terms governing whether and when an investor may receive the future equity vary from offering to offering. In short, despite its name, a so-called SAFE is neither ‘simple’ nor ‘safe.’ In the interests of educating investors about the potential risks associated with SAFE offerings, this week, our Office of Investor Education and Advocacy is releasing an investor bulletin on these particular types of instruments.
“SAFEs were first developed in Silicon Valley as a way for venture capital investors to invest quickly in a hot startup without burdening the startup with the more intense negotiations that an equity offering usually entails. For some venture capital investors, the value of obtaining an opportunity for a potential future equity stake exceeds that of protecting a relatively small investment in a SAFE. The terms of the SAFE, from the triggering events to the conversion terms, are typically designed to operate in the context of a fast-growing startup likely to need and attract future capital from sophisticated venture capital investors.”
Commissioner Piwowar describes a SAFE as “an agreement between an investor and a company in which the company generally promises to give the investor a future equity stake in the company if certain triggering events occur… An investor only receives an equity stake in a SAFE company if the specific terms of the security are met. If the terms are not met, the investor is left with nothing.” The clear implication is that SAFEs are not debt. To label them as debt, which entails a definite payoff amount within a definite time period, would be misleading.
SEC Investor Bulletin
An article on the SEC web site published on May 9, 2017 entitled, “Investor Bulletin: Be Cautious of SAFEs in Crowdfunding" warns individual investors about the relatively high risks of SAFEs. Excerpts from the article are copied below.
“A SAFE is an agreement between you, the investor, and the company in which the company generally promises to give you a future equity stake in the company if certain trigger events occur.”
“SAFEs do not represent a current equity stake in the company in which you are investing. Instead, the terms of the SAFE have to be met in order for you to receive your equity stake.”
“SAFEs may only convert to equity if certain triggering events occur.”
“Despite the identified triggers for conversion of the SAFE, there may be scenarios in which the triggers are not activated and the SAFE is not converted, leaving you with nothing. For example, if a company in which you invested makes enough money that it never again needs to raise capital, and it is not acquired by another company, then the conversion of the SAFE may never be triggered.”
“Different from SAFEs, convertible notes generally represent a current legal obligation by the company to you for the outstanding amount of the note.”
The SEC Investor Bulletin describes SAFEs as a contractual agreement whereby the investor will receive equity shares of the Company in the future, only if certain triggering events occur.
The SEC Investor Bulletin also correctly identifies convertible notes, which represent a definite legal obligation by a company that issues them, as “different from SAFEs”. The logical inference is short and easy: SAFEs are not debt.
Under a SAFE, an investor may get equity shares in the future; or the investor may lose all of his or her cash and get nothing in return.
Analysis and Application of Relevant Accounting Guidance ("GAAP")
Current authoritative accounting guidance, known as generally accepted accounting principles (“GAAP”) does not specifically address SAFES (because they are so new). Thus, in order to determine the proper accounting for SAFEs, it necessary to glean principles from GAAP rules governing other types of instruments and transactions.
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.
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 clear that financial instruments like SAFEs are not mandatorily redeemable, by definition, and therefore should be accounted for as equity and not liabilities.
ASC 480-10-25-14 states, “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:
- A fixed monetary amount known at inception (for example, a payable settleable with a variable number of the issuer’s equity shares;
- Variations in something other than the fair value of the issuer’s equity shares (for example, a financial instrument indexed to Standard & Poor’s S&P 500 Index and settleable with a variable number of the issuer’s equity shares; or
- Variations inversely related to changes in the fair value of the issuer’s equity shares (for example, a written put option that could be net share settled).”
Sub-parts (b) and (c) obviously are not relevant to SAFEs.
At first glance, sub-part (a) of this paragraph of the ASC seems to indicate liability accounting. However, upon more careful scrutiny and deeper analysis, it becomes clear that SAFEs are outside the scope of this particular paragraph.
As Paul Graham, Carolynn Levy, Commissioner Kara Stein, Commissioner Michael Piwowar, and the SEC Investor Bulletin all explain, SAFEs do not embody an unconditional obligation.
Furthermore, SAFEs do not embody a conditional obligation of a fixed monetary amount known at inception, as contemplated by part (a). ASC 480-10-25-14, sub-part (a) provides an illustrative example of the scope and intent of sub-part (a) of this paragraph: “a payable”. This paragraph is contemplating a liability obligation – a “payable” – that a 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.
The type of transaction being contemplated by sub-part (a) is the case of a company owing a certain amount of money to a creditor, and the debtor promising to pay the principal plus interest, in cash or liquid shares of the company’s stock. What is not explicitly stated, but what is implicitly clear, is that the shares to settle such a debt or payable would need to be liquid. For example, say a company owes a debt or payable of $10,000 to a creditor. The debtor promises to pay the principal plus interest by a certain date. The total amount to be paid will be something close to $10,000 – perhaps $10,100, perhaps $10,500 – with the excess over $10,000 constituting the agreed upon interest on the debt. The entire amount will be paid with cash or with shares of liquid stock that the creditor can quickly and easily convert to cash without risking any significant loss of value.
SAFEs, however, entail a transaction with a much different character than a debt or payable transaction. An early seed investor who purchases a $10,000 SAFE typically is given the right to have his or her $10,000 later purchase shares of Preferred Stock if the Company consummates a Preferred Stock round of financing in the future. If such a Preferred Stock financing occurs, the SAFE holder’s $10,000 will purchase shares of Preferred Stock at a per share price equal to the lower of:
- the price the new Preferred Stock investors pay;
- a price at a specified discount from the price the new Preferred Stock investors pay (a 20% discount is common); or
- the “Safe Price”, which is equal to the Valuation Cap divided by the fully diluted number of shares of common stock and potentially dilutive shares of common stock equivalents outstanding immediately prior to the conversion.
Note that in any case, the conversion price is not based on any sort of broad market value, but rather a price negotiated between the Company and a small number of early stage investors.
Note also that the shares of Preferred Stock anticipated to be purchased will be very illiquid. Probably it will be several years before the SAFE investors realize any cash return on their investment, if ever at all. Note also that the company could fail, and if that were to happen, the SAFE investors would not receive any return on their investment. Finally, also note that a company could potentially earn enough profit from operations, or receive enough cash from other SAFE investors, such that it might never need to execute a round of Preferred Stock financing, and it might decide not ever to execute a round of Preferred Stock financing, and in that case, the SAFE investors would never receive any shares of Preferred Stock or any cash return on their investment.
Under at least two difference scenarios, then, it is possible that the SAFE investors could lose their entire cash investment and never receive anything in return. It is not common for startup companies never to do a Preferred Stock financing round and choose never to provide a return to their SAFE investors; but it is very common for startup companies to fail and consequently for the SAFE investors to completely lose their cash invested and receive nothing in return.
Thus, the character of SAFEs is that of an early stage, venture equity investment, not a debt or payable transaction contemplated by ASC paragraph 480-10-25-14. Thus, SAFEs are outside the scope of ASC 480-10-25-14.
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 …”
As Paul Graham correctly analyzed, SAFEs are “not debt, but something more like a warrant.” SAFEs, in fact, are very much like equity call options or equity warrants, the key differences being that the exercise price has been prepaid upfront, and ownership of the anticipated equity shares comes later, if ever, based on contingent events over which investors have no control. Still, SAFEs are more like equity call options or equity warrants than anything else, and so SAFEs should be accounted for as equity call options and equity warrants are. Equity call options and equity warrants are accounted for and reported as additional paid in capital, within permanent equity, and so should SAFEs be.
ASC Subtopic 815-40 addresses “Contracts in Entity’s Own Equity” and so is relevant with respect to determining the proper accounting for SAFEs. Paragraph 815-40-25-1 states, “The initial balance sheet classification of contracts within the scope of this Subtopic generally is based on the concept that: (a) contracts that require net cash settlement are assets or liabilities; and (b) contracts that require settlement in shares are equity instruments.” Paragraph 815-40-25-4 further emphasizes, “... unless the economic substance indicates otherwise… Contracts shall be initially classified as equity in both of the following situations: 1. Contracts that require physical settlement or net share settlement …”
As has been explained and described in previous sections, SAFEs are contractual agreements between the Company and investors, whereby investors are granted the right to receive equity shares (namely shares of Preferred Stock), in the future, if certain triggering events occur. Thus, SAFEs are contractual derivatives of a company’s own equity. Accordingly, SAFEs should be classified as equity instruments.
SAFEs are very similar to equity warrants and should be classified as equity warrants are, in additional paid in capital, as part of permanent equity.
Corporate Finance Theory and Legal Precedent – Thin Capitalization Indicates Equity
Consider the thin capitalization of early-stage startup companies. Often, the only financing is in the form of SAFEs. Thus, for the sake of argument, even if SAFE agreements were written as debt agreements (they are not), it would still be necessary to reclassify the (presumed) debt to equity, because the associated risk and economic substance of the investment is that of equity, no matter what the related contract says it is.
Although the FASB has not addressed the issue of thin capitalization, both the U.S. Congress and the U.S. federal courts have addressed it with respect to tax and other legal issues, such as the disputes with respect to estate claims.
Section 385(b) of the U.S. Tax Code provides the following factors that the U.S. Treasury should consider in determining whether a financial instrument nominally designated as debt should be recharacterized as equity.
- When an instrument contains a written unconditional promise to pay on demand or on a specified date a sum certain of money and to pay a fixed interest rate, it more closely resembles debt.
- Being subordinate to other debt indicates that an instrument represents equity.
- A high debt-to-equity ratio suggests an equity instrument because most creditors would consider it too risky to lend money to a business with a high level of preexisting debts.
- An equity classification is more likely if the holder can convert an instrument into stock.
- Advances contributed by shareholders proportional to their equity holdings are more likely to be deemed equity contributions’.
In Estate of Mixon, 464 F.2d 394 (5th Cir. 1972), the U.S. Federal Fifth Circuit Court of Appeals enumerated the following factors to distinguish between debt and equity.
- An instrument labeled as a note is more likely to be considered to represent debt.
- Fixed maturity dates support a debt classification.
- If repayments are primarily tied to the ability to generate earnings, an equity classification is more probable.
- The ability to demand repayment of advanced funds indicates a debt instrument.
- The equity classification would seem more likely if an instrument provides the ability to participate in management.
- Advances subordinate to other corporate loans are close to the equity classification.
- The instrument’s debt-equity determination should be influenced by evidence of what the parties intended to create.
- An instrument issued to a thinly capitalized business more closely approximates equity because creditors generally pursue more secured investments.
- If a shareholder advances funds in proportion to his or her equity ownership, the instrument resembles an equity contribution.
- An instrument that allows interest payments to be primarily dependent upon the availability of future earnings (i.e., dividend money) is more likely to be considered equity.
- Evidence that a corporation could receive financing from other third-party lenders increases the chance that an instrument will be classified as debt.
- The use of funds for capital outlays indicates debt status, whereas their use for normal operating expenditures represents equity status.
- Actions such as the debtor’s failure to repay on the due date or seek a postponement demonstrate a lack of concern in making repayments and suggest that the instrument has equity characteristics.
The preponderance of legal considerations, including early-stage startup companies’ thin capitalization, indicate that the legal characterization of the Company’s SAFEs is equity and not debt. Accounting should follow the legal characterization as well as the economic substance of the transaction.
Priority of Claims in a Hypothetical Bankruptcy or other Liquidation of Assets
In a bankruptcy proceeding or other liquidation of a company’s assets, a SAFE investor’s position would not be senior to, or even on parity with, those of secured or unsecured creditors. We believe that the courts would consider any assertion of such a supposed right by a SAFE holder to be without merit and worthless. This view is consistent with Commissioner Stein’s and Commissioner Piwowar’s concerns about the relatively high risk of SAFEs.
Conclusion – SAFEs Should be Classified as Additional Paid-In Capital within Permanent Equity
Y Combinator cofounder Paul Graham, former Wilson Sonsini and current Y Combinator attorney Carolynn Levy, SEC Commissioner Kara Stein, SEC Commissioner Michael Piwowar, and the authors of an SEC Investor Bulletin about crowdfunding all agree about the facts and circumstances of SAFES: SAFES are not obligations of companies to pay fixed amounts to lenders or creditors; they are not debt. Instead, SAFEs are contractual derivatives of the Company’s own equity, very much like equity call options or equity warrants. Accordingly, SAFEs should be accounted for as additional paid-in capital, within permanent equity.