The very first Regulation Crowdfunding (“Reg CF”) campaign I worked on when Reg CF first became legal, was the same engagement I saw my very first Simple Agreement for Future Equity, better known as a SAFE. My reaction was what you can imagine….”what the heck is this!”
For those who don’t know, a SAFE is an agreement whereby an investor provides an investment into a company that is converted to preferred equity security when AND IF a preferred equity is issued through a qualifying capital raise. It is not repayable like debt, it does not carry interest like debt, and the risks and rewards are more aligned with an equity investor. There is a chance the company never undertakes a preferred round because they are wildly successful and therefore the SAFE’s never have to be converted and investors are never paid back unless there is a change in control event. It is truly a risky bet by an investor, especially a retail investor.
First, let’s explain why this guidance is so important. Reg CF is picking up steam and by the end of 2017 I would expect somewhere between 600-800 companies will have gone through a campaign or will be actively going through one. That is a lot of companies in about a year and a half. Right now, general statistics are saying that SAFE agreements make up about 20-25% of current Reg CF raises. That is a lot of companies that will carry those investments on the balance sheet, many of which will be required to report to their investors in future years.
Since my first interaction with a SAFE, I’ve scoured the internet for guidance, contacted all my friends in the Big 4 for potential guidance, and called all my collogues who work with technical accounting and SEC reporting. I generally get the same response form everyone: “Never heard of it” or “I’m not sure how to account for it.”
I’ve had some clients that want to classify SAFE’s as long-term debt and others as equity. Through trial and tribulation, review by regulators and colleagues alike, I can finally claim that I have the official…unofficial accounting guidance that I believe will apply to most common SAFE agreements. This accounting treatment has been reviewed and agreed to by the SEC based on actual facts and circumstances. As a disclaimer because all SAFE’s are different, this guidance may not apply to every SAFE.
Most SAFE should be classified as a liability, likely a long-term liability. Let’s get the conclusion out there and go through the “why” next.
SAFE’s provide the company with an obligation to deliver a variable number of shares based on a future unknown priced round (discounted) or a valuation cap. This would generally lead you to Accounting Standards Codification (“ASC”) 480-10-14 which talks about a variable number of shares for a fixed or predominately fixed monetary amount. However, this guidance doesn’t apply because the settlement of future preferred shares may be worth significantly more than the original investment, or may never be issued. Therefore, the end value is not predominately fixed like it would be if you were settling a payable.
This brings us to ASC 815-40. Without going into the extreme details, this guidance tells us that the SAFE is debt because of a few factors. The first is that the SAFE is not indexed to the Company’s own stock per ASC 815-40-15-5 through 15-8a, see ASC 815-40-55-33 as an example. Thus, equity classification is precluded. If for some reason the SAFE was considered to be indexed to the company’s own stock, there would be other considerations that would still cause the SAFE to be classified as debt, which can be found in ASC 815-40-25-7 through 25-35. Some of the ones that may apply are:
· There may be an exercise contingency included in the SAFE.
· The rights of a SAFE holder will generally be higher than that of the common shareholder underlying the contract. Therefore, there are preferential rights.
· The number of shares that could be required to be delivered upon net share settlement is essentially indeterminate. Meaning, there is a theoretical possibility that preferred shares could be priced lower and lower such that an infinite number of shares would be required to settle the SAFE which would be more than the shares available to be issued (probability or likelihood of such happening is irrelevant).
Well, that’s great but it still doesn’t tell you how to account for it. So next the guidance will shoot you to ASC 810-10 which talks about derivatives. Ultimately, the SAFE’s are one big derivative. Simplified, a bet with multiple underlying factors. ASC 815-10 will likely tell you that the SAFE should be recorded at fair value and marked to market periodically.
What the heck does that mean?
That means that the Company will be required to carry the safe as debt on the balance sheet (think of it as an obligation rather than debt) and value the SAFE’s periodically to write the value up or down and record a gain or loss based on the fluctuation of the value. So how do you value the SAFE? Well, that’s a whole other blog and a whole other matter. The simple answer is, a wild guess by management based on the best information they have, or having to use a valuation specialist (preferred method but costlier). When you are actively selling the SAFE’s the fair value is generally known, it will be the same value you are selling them for. If time passes between the SAFE offering and the reporting period, especially when additional offerings have occurred, then the SAFE will likely have a different value and you should use a valuation specialist to assist.
The unfortunate thing about this, is SAFE's were created to make things easier for early stage companies. Make things less complicated and less costly. But guess what….it is actually going to make everything much more complicated and much more expensive.
dbbmckennon is a full service CPA firm with offices in Orange County, San Diego and Santa Monica. We specialize in companies filing with the SEC and utilizing equity crowdfunding through Reg A+ and Regulation Crowdfunding. For additional complimentary information regarding this topic or other questions you may have please call one of dbbmckennon‘s offices located in Southern California or contact us here.