Technology and Health & Life Sciences
How Startups Can Account for SAFE/KISS Agreements under GAAP
Finding a way to raise capital that doesn’t have a lot of risk attached to it is a big, keep-you-up-at-night concern for startups. Conventional capital-raising tools, such as convertible notes and shares of stock, come with risks and significant costs for entrepreneurs and business owners. These risks can include losing operating control of the company they built or having to pay back large amounts of debt to investors even if the company fails, to name only two.
A new mechanism for raising capital early in a startup’s development is something called a simple agreement for future equity, or more commonly referred to as a SAFE. These agreements are also sometimes referred to as keep it simple securities, or KISS. (The terms can be used interchangeably.) While these agreements are more prevalent with startups, they are used in other high-growth companies as well.
What Are SAFEs and How Are They Different?
A SAFE is an agreement between investors and startup owners. The investors agree to give the owners money to help them grow their business. However, the investment money doesn’t immediately give the investors equity in the company, as with more traditional investment tools. Instead, a SAFE is an agreement that the investment money will turn into equity shares once certain trigger events happen.
Some high-level things to know about a SAFE or a KISS are:
- One of the biggest differences is that SAFEs allow a startup to raise capital without incurring debt, because a SAFE is not a debt instrument; it has no equity value until a trigger event happens.
- A SAFE is not a loan; therefore, it doesn’t accrue interest.
- A SAFE addresses valuation issues that plague many traditional investment tools, since valuing a young business can be tricky.
- Investors could walk away with nothing if the company fails before the trigger events happen or if those events never happen at all even while the business continues.
- There is no standard SAFE or KISS; each agreement is meant to be simple (usually only a page or two), which often saves time and legal fees for companies, since the only items to negotiate should be the valuation cap and trigger events.
One potential side effect of SAFEs is that they have the ability to shift risk, which up until now has rested largely on startups, more evenly between owners and investors. (Some guidance, such as in this bulletin issued by the Securities and Exchange Commission, would say that the risk is shifted almost entirely to investors, depending on the provisions in the SAFE.)
Convertible notes and other debt interests can have negative unintended effects on startups, since investment tools that incur debt can be subject to regulations, have maturity dates, and can have security interests and subordination agreements, all of which can threaten a startup with insolvency. Not being a debt instrument, a SAFE can be a more secure way of raising startup funds.
How to Account for SAFEs in GAAP
If SAFEs aren’t a debt instrument, how does a privately held company account for the cash received when using generally accepted accounting principles (“GAAP”)?
The general guidance is that the money that comes in from SAFEs is treated as a debit to cash. You would account for SAFEs as “credit paid in capital – SAFE” as a non-dilutive component of equity.
Once the trigger events happen and it’s time to exercise the SAFE or KISS, then you can debit the amount as “paid-in capital – SAFE” and record the stock issued. After making this adjustment, the accounting treatment realigns the transaction to mirror a more traditional accounting entry as if common or preferred stock was originally issued.
Each SAFE should be evaluated separately. While the idea is for SAFEs to be simple, if significant terms are included in a SAFE, the accounting treatment could result in a different answer.
The simplicity of these kinds of investor agreements makes it a potentially useful tool for startups looking to raise capital and for investors looking for an easier way to invest in promising opportunities.
How to raise and account for seed capital isn’t the only challenge startups face. Decisions you make now about how you raise capital and claim deductions and losses can affect you far into the future. Getting the right answers early and planning ahead could make a difference in how much capital you have on hand to fund projects and growth into the future.
About the Authors
Stacy LaMontagne, CPA, Partner in Assurance Services, works from the Firm’s D.C. office to provide accounting, financial reporting and audit assurance services for clients within the technology and life sciences, private equity and venture capital, government contracting and hospitality industries. One of her specialties is assisting technology and life sciences companies with complex revenue recognition treatment related to bundled software and services and other multiple-element arrangements. She also has experience working with complex financial instruments, such as convertible debt, preferred stock and SAFEs. Stacy is very active in the startup community in the D.C. area. Prior to joining the firm, she was a senior manager and director at one of the nation’s largest accounting firms.
Ronnie Eubanks, CPA, Partner in Assurance Services, works from the Firm’s Durham office advising venture-backed, private equity and other privately-held businesses on matters including corporate structure, evaluating and selecting the most effective internal finance structure (including financial reporting and modeling to potential and current investors), cash flow analysis and operational assessment. He is a member of THInc (Technology, Health & Life Sciences, and Industrial), the Firm’s specialty practice focused on guiding growth through innovation. In addition to working with THInc industries, Ronnie works with manufacturing, nonprofits, construction and wholesale distributors to help them achieve growth, meet short- and long-term goals and plan for unnecessary setbacks.