CEOs and CFOs of startups and emerging growth companies often turn to SAFE agreements as a reliable financing source, especially during times when sources of investment capital are difficult to come by and debt financing is too expensive.
Our team has outlined the importance of SAFE agreements, the accounting complexities they bring, as well as some challenges you may face when you have to account for them under GAAP (generally accepted accounting principles in the U.S.).
Important things to know about SAFE agreements:
- What a SAFE agreement is
- How SAFE agreements work
- The importance of accounting for SAFE agreements
- Why the accounting for SAFE agreements is complex for startups and emerging growth companies
- How SAFE agreements differ from 409A valuations
What is a SAFE agreement?
A Simple Agreement for Future Equity (SAFE agreement) is a financing instrument used by startups and early-stage companies to help them simplify and accelerate their fundraising.
How do SAFE agreements work?
When a company executes a SAFE agreement, it enters into a legal contract with its investor. In exchange for an investment today, the investor receives the ability to apply this investment towards a company’s future equity round.
To make the arrangement attractive for the investor, a SAFE agreement can provide for conversion into company shares in the future at either a discount on a future per share issue price or based on a defined “SAFE price” that takes into account the value of a company today. Both of these structures enable today’s investor to receive more shares of a company than they would have if they had waited to invest in a future financing round.
In this regard, a SAFE agreement can be viewed as an alternative to convertible debt. Unlike a convertible debt instrument, a SAFE agreement typically does not have a stated interest rate or maturity date.
A SAFE agreement may also have equity-like characteristics, however, unlike a conventional equity investment, a SAFE agreement does not provide the investor with any rights typically inherent in investments in equity shares such as voting or dividend rights.
Why does the accounting for SAFE agreements matter for startups and emerging growth companies?
The accounting for SAFE agreements in accordance with GAAP is typically not top of mind when companies first issue them, and rightfully so. But as the company grows and seeks additional funding, investors may need additional information about these agreements, including requiring full GAAP compliance.
Not only can the application of GAAP be complex, but its initial implementation will likely require multiple adjustments to a company’s historical financial statements. Determining and supporting these adjustments is time-consuming and will require technical accounting expertise.
Additionally, in many circumstances, the company will have to report the SAFE liability at fair value, not historical cost. To comply with this requirement, the company will need to engage a valuation specialist, which will add time and cost to the GAAP conversion that management should take into account once they decide to issue fully GAAP-compliant financial statements.
Why is the accounting for SAFE agreements complex for startups and emerging growth companies?
The balance sheet classification of a SAFE agreement is one that requires a careful evaluation of all settlement terms and an understanding of areas of GAAP that entail a high level of complexity, namely, ASC Topic 480, Distinguishing Liabilities from Equity, and ASC 815-40, Contracts in an Entity’s Own Equity.
Of late, the majority of the SAFE agreements we see contain settlement terms which result in liability classification.
This requires that a SAFE agreement be reported at fair value both at inception and on an ongoing basis during the time that it remains outstanding. As a result, a company will require the assistance of a valuation specialist to determine the related fair value on any given balance sheet reporting date.
The changes in the instrument’s fair value over time are recorded as a component of net income or loss in the statement of operations and, accordingly, also introduce variability in operating results.
How is the 409A valuation different from the fair value of the SAFE agreement?
A 409A valuation establishes the fair value of the company’s common stock using the guidelines and standards established by the American Institute of Certified Public Accountants Accounting and Valuation Guide, Valuation of Privately-Held Company Equity Securities Issued as Compensation, for the purpose of setting the exercise price of stock options to employees and other service providers.
A 409A valuation is required under Section 409A of the Tax Code to validate that stock options are granted at a price that reflects their fair value.
A valuation expert engaged to estimate the fair value of a SAFE agreement will most likely leverage the 409A valuation as a starting point but then must consider the unique terms of the SAFE agreement, the probability and anticipated timing of the SAFE agreement trigger events (such as the probability of a future financing round), discount rates and other matters to determine the fair value of the SAFE agreement.
In other words, an additional valuation separate from the Company’s 409A valuation will be required.
Going forward, as noted above, the company must update their fair value estimate of the SAFE agreement.
Final Thoughts on SAFE Agreements for Startups and Emerging Growth Companies
SAFE agreements have been a successful fundraising tool for many of our startups and emerging growth companies. Be aware that if your company has previously raised funds through a SAFE agreement, your historical financial statements will probably need to be adjusted once you are required to prepare them in accordance with GAAP.
The accounting can be tricky, and the valuation requirements will take time – but the benefits to be gained from SAFE agreements should far outweigh these additional costs and effort.