Taking Account of SAFEs

A relatively new security known as a Simple Agreement for Future Equity–or SAFE for short—is an investment vehicle that has become ubiquitous in early-stage startups for raising capital.

We here at Juna have fielded numerous questions from clients inquiring about SAFEs and the newly resulting accounting issues about how to report them on balance sheets. We always stay up to date on the latest issues facing our clients and we have taken great care to educate clients and become more versed ourselves in these financial instruments.

Just what are SAFEs?

In essence, a SAFE is an agreement between an investor and an early-stage company to provide capital in exchange for a promise of future equity when a triggering event occurs, usually an equity raise or a sale of the company. So, it’s cash in exchange for a promise of equity in the future.

SAFEs are primarily used as a pre-seed or seed round by fast-growing startups that will need additional capital through an eventual equity raise. Their popularity in part is because they are easier for companies to pursue than raising equity or convertible debt, and their simplicity makes the transaction costs lower and faster to close. Additionally, there is no negotiation of value for the company because the number of shares the investor receives is based on a future financing or sale when the value is determined.

Raising equity capital vs. SAFEs

To better understand this financial dynamic, think of raising equity capital as option one and SAFEs as option two. When a company seeks to raise equity capital, they typically go to a venture capital firm or angel investor. They might say that they’re going to be the next unicorn (who doesn’t right?), and ask for millions of dollars. In return, the unicorn wannabe says, we will give you equity in the company in the form of a certain number of shares of preferred stock based on a negotiated valuation for the company. There are term sheets to negotiate and attorney fees and all sorts of expenses and legalities that come with it.

With a SAFE, there is no equity issued and there is no set future number of shares. Instead, the agreement typically calls for the number of shares to be based on a future equity raise or sale of the company where the value of the company is determined. Because there are fewer terms to negotiate in a SAFE, the legal fees are lower.

To illustrate, let’s say an indoor beach volleyball company is seeking $100,000 to get their company off the ground. They issue SAFE investments and raise the capital. Two years into the future, the company has started operations and has a loyal customer following. They want to expand operations and open up new facilities. The company raises $1M in preferred stock from an angel group and negotiate a value of $10M and there are 10M shares outstanding. This is called a “priced round” because the value of the shares has been determined ($1 per share). At that time, the SAFE investments will convert to equity shares. SAFE investors typically convert at a discount to the priced round. If the SAFE investment has a 20% discount, their investment will be converted at 80 cents per share. That means that their investment of $100,000 entitles them 125,000 shares.

But what happens if the beach volleyball company never sells, or if they become super successful and decide to franchise instead of raising equity capital? Simply put, the investor is out of luck. In this way, SAFE is riskier for investors because they are relying on one of the triggers to occur for it to actually turn into equity. The discount to a future priced round is intended to compensate investors for this risk.

Raising convertible debt vs. SAFEs

The basic concept of convertible debt is that the investor is legally entitled to either get paid back with interest or convert the investment to equity. Convertible debt is safer for the investor than equity because if the company goes belly-up, they get paid before equity holders get paid. If the company is super successful, the debt converts to equity. So investors are protected on the downside, but also participate on the upside. 

The key distinction between convertible debt and SAFEs is that a SAFE investment is not debt, so the company has no legal obligation to pay it back – ever. And it will only convert to equity if a triggering event occurs.

Recording SAFEs on balance sheets

So how should companies record SAFEs if it’s not debt, but not equity either? Curious, we put the following informal poll question to our Juna team: “Where should a SAFE investment be recorded on the balance sheet? As debt or equity?”

Poll results showed that eight of us (67 percent) said it should be recorded as equity while four (33 percent) said it should be recorded as debt. The truth is there is no wrong answer. The reality is that there has been no formal guidance from the SEC on the matter.

Still, it didn’t keep any of us from having some strong perspectives. One of us thought it should be recorded as debt, likening it to a contingent liability. Another agreed, but also pointed out that an expert column she read said “treating it as equity is not wrong.”

That prompted another Juna team member to say it should be recorded as equity. “There’s no recurring interest like a convertible note and it never has to be repaid so I could see it going to the equity side,” she said. “It will never have to be repaid like a liability.”

Well said.

Pending guidance from the Financial Accounting Standards board (FASB) on the accounting treatment of SAFE investments, we record them as equity on the balance sheet for our clients.

In the end, our discussion about SAFE investments goes to the heart of Juna: We’re always thinking, probing, and analyzing what’s best for our clients. We know that they look to us for guidance. And we are continually partnering with our clients’ as well to do what is in their own best interests.

Now that’s what we call a safe bet.