Accounting For SAFE Notes – Part I

Overview

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:

Term:

  • No maturity date is specified within a SAFE note.

Interest:

  • No interest is required to be paid to the SAFE note holder by the Company.

Conversion terms:

  • 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.

Other items:

  • 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. Which we will begin within the next post “Accounting For Safe Contracts – Part Two.” Stay Tuned!

About the author:

Brian Engelhardt is a partner at Balanced Solutions. Brian is a CPA, also began his career at PwC in the private company assurance group serving primarily service-companies in the Washington, DC metro area as well as Cleveland.  After leaving PwC after eight years, Brian ventured into accounting and finance consulting working primarily with technology companies. Learn more

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