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Published May 17, 2021

Simple Agreement for Future Equity: Cutting Through the Confusion

Simple Agreement for Future Equity (SAFE) has developed into an attractive way for companies, generally startups or early-stage entities, to raise money inexpensively. But unlike the name suggests, accounting for the awards has proven anything but simple. At present, the Financial Accounting Standards Board (FASB) has not issued guidance specifically related to the accounting for SAFEs, and that has led to some discrepancy as to how SAFEs should be accounted for at the time of issuance.

Background

SAFEs were created in 2013 by Carolynn Levy, a partner at Silicon Valley venture fund Y Combinator, to provide an alternative to convertible notes. The article “Announcing the Safe, a Replacement for Convertible Notes” observed, “Carolynn has created a replacement that is essentially convertible debt without the debt.” Basically, SAFEs are convertible notes, but without stated maturities or interest expense. 

SAFEs allow a company to receive cash without the legal costs typically associated with traditional convertible debt or equity raises. They generally contain provisions that detail how the award can be converted to a future equity stake in the company, often at a discount to what other investors would be required to pay. These provisions are typically triggered by defined conversion events, such as future equity raises or acquisition by another company. 

Over the last several years, SAFEs have gained popularity, particularly with venture capital funds and other early investors. SAFEs carry a unique component of risk because there is always the possibility that the company will never trigger the conversion features built into the SAFE, essentially making the investment worthless. Investors are willing to shoulder this risk because SAFEs provide them an inexpensive form of early investment in a business.  Companies enjoy the benefits of SAFEs because they afford the ability to raise capital in a shorter timeframe than is typically associated with more traditional methods.

Liability or Equity?

When evaluating the accounting for SAFEs, issuers of the awards should consider guidance applicable to financial instruments that are not issued in the form of outstanding shares of stock. It is also important to note that each SAFE will have unique features that could result in varying opinions related to its classification

Some SAFEs include an obligation or are indexed to an obligation, to repurchase shares, requiring the issuer to settle through a transfer of cash or other assets and, as such, are considered a liability of the issuer. Instruments that allow the investor to receive shares of the company’s stock in exchange for cash or other assets, even if only on certain contingencies, and that are indexed to the company’s stock price, are also generally liabilities. Additionally, SAFEs often embody a conditional obligation indexed to a company’s stock that requires the issuing company to transfer cash or other assets upon certain contingent events. Such events might include a liquidity event or equity raise, which can result in possible liability classification and mark-to-market accounting. 

The number of shares that a purchaser of a SAFE will receive is generally unknown at the time of issuance and is thus indexed to the stock price of the entity at the time of conversion. However, SAFEs may also meet certain criteria related to instances where the issuer must or may settle by delivery of a variable number of shares, and the value at inception is predominately based on one of the following:

  1. A fixed-dollar amount
  2. Something other than the issuer’s shares
  3. Inversely related to the fair value of the issuer’s shares

SAFEs can require the issuer to deliver a variable number of shares with the value received by the investor equal to the invested capital, plus a fixed premium (the discount defined in the award). Additionally, the issuer typically controls the events that may trigger settlement in a variable number of shares, and thus it is not an obligation of the issuer to settle a SAFE. Under this interpretation, SAFEs may not be classified as a liability.

However, even if a SAFE is not a liability due to the criteria noted above, a SAFE can only be classified as equity if it is both:

  1. Indexed to the issuer’s stock.
  2. Eligible for equity classification as defined by FASB.

If a SAFE is not a liability for one of the aforementioned reasons, there is a chance that it may not meet the requirements for equity classification. This could be the case if the SAFE has rights that rank higher than shareholders of the underlying stock or if there is not an explicit limit on the number of shares issuable on settlement.

Regulators Weigh In

In a May 2017 Investor Bulletin, the Securities and Exchange Commission (SEC) warns investors about SAFEs: “The most important thing to realize about SAFEs is that you are not getting an equity stake in return. SAFEs are not common stock.” The SEC makes it clear to investors and other companies wanting to perform this type of funding that it is not automatically equity. The SEC does not state anywhere in the article that a SAFE is a liability or equity, but is quick to note that SAFEs are not traditional equity.

What Should Be Done?

Even though FASB has not yet issued any standard specifically addressing this topic, it is sufficient to believe that as long as companies are looking for simple ways to fund their businesses, SAFEs will continue to be an attractive form of funding. Until a standards body weighs in, however, it will be up to the individual companies offering SAFEs to evaluate the awards on a case-by-case basis. While there may be obvious financial statement benefits to classifying SAFE awards as equity as opposed to a liability, a Company should be careful to consider the specifics of the instruments they are issuing. 

If you have questions related to accounting for SAFEs or need additional guidance related to business management and advisory or audit and accounting, contact a PYA executive below at (800) 270-9629.

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