Hey SEC. Seriously - SAFEs are Equity, not Debt.

In a land far, far away, in a tall ivory tower, an ongoing debate is raging about whether SAFEs (Simple Agreements for Future Equity) should be accounted for as debt, or as equity.  Who could have imagined there would ever be such a debate?!  You can read the background information about this issue in our article Hey SEC! SAFEs are Equity not Debt!

There is no doubt in the mind of Carolynn Levy, the Y Combinator lawyer who created SAFEs as to what they are; she created them specifically to make sure they are equity and not debt.  You can read more about that in this article Y Combinator Introduces SAFE, its Alternative to Convertible Notes.  SAFEs have been around for almost four years now, since Y Combinator introduced them in 2013.  In the Silicon Valley and San Francisco startup scene, we all are familiar with SAFEs and understand intuitively what they are.  But now, because of the recent advent of crowdfunding, the public servants at the United States Securities and Exchange Commissione (the "SEC"), the federal police of stock markets and public investing in the United States, have taken notice of SAFEs, as evidenced by this article SEC Commissioner Stein Refers to SAFEs as Contractual Derivatives and this one SEC Commissioner Piwowar Says SAFEs Carry Greater Risk than Common Stock and this one SEC Bulletin Urges Caution Regarding SAFEs.  In the world of finance, it looks like 2017 is the Year of the SAFE!

The crux of the matter is this: U.S. GAAP (Generally Accepted Accounting Principles) pronouncement ASC 480-10-25-14 prescribes debt treatment of a financial instrument 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.  But that is not the factual circumstance with SAFEs.  With SAFEs, the monetary value of the obligation (the payoff to the SAFE investor) is based primarily on the relative difference between the "Valuation Cap" (a term of the SAFE agreement) and the actual pre-money valuation of the Company when the SAFE investment is converted into Preferred Shares.  The Valuation Cap is designed artificially low in order to generate an initial return on investment to SAFE investors of 200% to 400% upon conversion of the SAFEs into Preferred Shares.  

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:

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:

• The actual market 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

• The “Valuation Cap” that is part of the SAFE agreement, and especially the degree to which the Valuation Cap is less than the actual market 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 market 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.

Realistic projected payoff scenarios for a Company’s actual SAFE investors are shown below.  The projected payoff scenarios are realistic, based on typical conversions of SAFE investments in early-stage startup companies in the Silicon Valley / San Francisco Bay area.  This analysis shows that the payoff to SAFE holders is binary: it’s either negative 100% (they lose all their investment with nothing to show for it), as shown in Scenario 1, or a positive return between 200% and 400%, as shown in Scenario 2.  The primary determinants of the SAFE payoffs are: (i) the success or failure of the Company; and (ii) the relative difference between the SAFE Valuation Cap and the actual pre-money value of the Company at conversion.  Note that Scenario 2, which is the possibility that the SAFE investor receives shares of equity roughly equal to his or her initial investment is extremely rare; the probability of Scenario 2 occurring is very nearly zero.  The reason for this is that if the actual value of the Company were to be less than or equal to the Valuation Cap (which is very low), the Company almost certainly would not get additional funding and would therefore go out of business.  Thus, Scenario 2 would just become Scenario 1 (the SAFE investors would lose their investment).

SAFEs should be accounted for as equity, specifically, additional paid-in capital, and most certainly not debt.