Simple Agreements for Future Equity (SAFE) notes have gained popularity in recent years, especially with start-up companies. These notes enable a company to obtain funding without diluting their ownership percentage. In return, an investor receives the right to participate in future equity rounds. SAFE notes can vary but generally operate the same way. Below is a brief overview of key terms:
No maturity date is specified within a SAFE note.
No interest is required to be paid to the SAFE note holder by the Company.
Discount – enables the investor to participate in future equity rounds at a discount. For instance, let’s say that an investor purchases a $100,000 SAFE and a Series A preferred round occurs a year later. The SAFE note has a discount of 80%. If Series A preferred shares are priced at $1.00 per share, the investor would be able to convert its SAFE into Series A preferred shares at $0.80 per share (80% – effectively a 20% discount). This results in 125,000 shares being issued. At a valuation of $1.00 per share, the investor’s stake in the company is now worth $125,000. Note that in the circumstance in which the SAFE notes only have a discount, the value that will be received in the future (if there is an equity round) is already known by dividing the SAFE note value by the discount rate.
Valuation cap – enables the investor to participate in future equity rounds based on a valuation cap. For instance, let’s say that an investor purchases a $100,000 SAFE note and a Series A preferred round occurs at year later. The SAFE note does not have a discount, but it has a valuation cap of $20,000,000. The pre-money valuation of a company is $30,000,000 at $1.00 per share (i.e. 30,000,000 shares outstanding). When the SAFE note converts into preferred shares, it will convert based on the lower of the $30,000,000 valuation or the $20,000,000 valuation cap. In this example, as the valuation cap is lower than the valuation, the shares would convert at a $20,000,000 valuation (i.e. $20,000,000 / 30,000,000 shares outstanding = $0.66 per share). As such, a total of 150,000 shares will be issued ($100,000 / $0.66 per share). With a valuation of $1.00 per share, the investor has increased its stake in the company to $150,000. Note that in the circumstance in which the SAFE notes have a valuation cap, the value that will be received in the future (if there is an equity round) is unknown as the value of the company may come below, at, or above the valuation cap.
Both – some SAFE notes have both a discount and valuation cap. Generally, whichever feature results in the most shares being issued to the investor is the triggering feature.
When looking at a SAFE, also look at how the conversion terms work under different events. While SAFE notes generally focus on equity rounds, there are usually terms included for a change of control or liquidity event, which allow for conversion into equity or cash at the holder’s option.
Now that we have a brief overview of SAFE notes, the next question is how to account for them.
Accounting for SAFE notes
Evaluating whether the SAFE notes are freestanding or embedded
The first step in evaluating the SAFE notes to determine whether they are freestanding or embedded instruments. Per the ASC Master Glossary, a freestanding financial instrument is an instrument that meets either of the following conditions:
It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.
SAFE notes that issued separately from other financial instruments would be considered freestanding. If a SAFE note happens to be embedded within another financial instrument (i.e. debt or preferred stock agreement), it may be considered embedded if certain terms apply. However, usually this is rare for SAFE notes as they are issued separate from other financial instruments and, thus, are considered freestanding.
Evaluating the host instrument
The second step in evaluating the SAFE notes is to determine whether the SAFE note is a debt host, equity host, or neither. Debt hosts are generally issued in the legal form of debt, while equity hosts are generally issued in the legal form of shares. In evaluating SAFE notes, they generally aren’t issued in the legal form of debt and are clearly not in the legal form of shares (even though they may convert to shares at a later point in time). Additionally, SAFE notes do not have a maturity date, repayment schedule, or interest rate, which are typical terms in debt instruments. Based on this evaluation, it appears that SAFE notes are not in the form of a debt host or an equity host. As they are not in the form of a debt host (Accounting Standards Codification (ASC) 470: Debt), they should be initially evaluated under ASC 480: Distinguishing Liabilities from Equity.
Evaluation under ASC 480
The third step in assessing the accounting for the SAFE notes is to evaluate them under ASC 480.
Do the SAFE notes meet the guidance within ASC 480-10-25-4 (i.e. mandatorily redeemable instruments)?
A mandatorily redeemable financial instrument is an instrument issued in the form of shares that embodies an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur. As SAFE notes are not issued in the form of shares and redemption is based on a conditional event, they are not mandatorily redeemable. As such, this section of ASC 480 does not apply.
Do the SAFE notes meet the guidance within ASC 480-10-25-8 (i.e. obligation to repurchase an issuer’s equity shares by transferring assets)?
Although the SAFE notes may ultimately be settled by transferring assets (i.e. cash), the SAFE notes are not obligations to repurchase the Company’s equity shares and are not indexed to such an obligation (i.e. this condition is for the determination of whether an instrument is indexed to a written put option on the entity’s own stock). Note that the SAFE notes contain written equity call options (as opposed to put options). Therefore, this guidance is not applicable.
Do the SAFE notes meet the guidance within ASC 480-10-25-14 (i.e. certain obligations to issue a variable number of shares)?
ASC 480-10-25-14 indicates that 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 one of three conditions.
Note that two of the conditions are not applicable. These conditions relate to an obligation that is indexed to something other than the fair value of the issuer’s equity shares (i.e. S&P 500) and variations that are inversely related to changes in the fair value of the issuer’s equity shares. These conditions are not applicable as the SAFE note obligation is generally tied to the issuer’s equity shares and is not inversely related (i.e. obligation increases as the value of equity shares increases).
The third condition is applicable, which is settlement at a fixed monetary amount known at inception. As noted in the “Overview” section, if a SAFE note only includes a discount upon conversion, the ultimate settlement amount is known at note issuance (i.e. $100,000 note at a 20% discount will convert into $125,000 of equity shares). Therefore, if a SAFE note only includes a discount, ASC 480-10-25-14(a) would be applicable. If the SAFE note only includes a valuation cap, this guidance is not applicable and evaluation under ASC 815-40: Derivatives and Hedging: Contracts in Entity’s Own Equity would occur. If the SAFE note includes both a discount and a valuation cap, a predominance assessment should be performed. The predominance assessment would evaluate the likelihood of conversion of the SAFE notes via a discount or via the valuation cap. If both conversion scenarios are relatively equal in likelihood, ASC 480-10-25-14(a) would not be applicable and we would jump to ASC 815-40. If conversion at a discount is predominant to a conversion at a valuation cap, ASC 480-10-25-14(a) would be applicable.
Note that in practice, we would generally conclude that neither conversion event is predominant, unless the valuation cap is so high that it would be unlikely it would ever be triggered (in that case the conversion at a discount would be predominant).
Accounting for SAFE notes under ASC 480 and ASC 815-40
As the SAFE notes are accounted for under ASC 480, they will be recorded initially at fair value. Fair value is generally assumed to be the transaction price at issuance. For instance, if a $50,000 SAFE note is issued, the fair value on the issuance date is assumed to be $50,000. Under ASC 480, SAFE notes would be subsequently measured at fair value at the end of each reporting period with gains or losses recorded in earnings.
Under ASC 815-40, the SAFE notes would go through further evaluation to determine whether they are indexed to the company’s own stock. Generally they would not be indexed to the company’s own stock and would be recorded as a liability initially and subsequently at fair value with gains or losses recorded in earnings.