The Simple Agreement for Future Equity (SAFE) has been around for several years now. While it has its critics, it is among the most common form of financing for early stage high risk/reward startups. As an equity alternative to convertible debt instruments, SAFEs are generally accounted for as equity on a startup’s balance sheet. (Keeping debt off the balance sheet, after all, is one of the features that SAFE advocates cite as an advantage over conventional convertible debt instruments.)
Without going into too much detail, the argument for accounting for SAFEs as equity (and not some sort of debt) is based on common sense, in the form of looking at how something similar to SAFEs is traditionally accounted for. In this case, the SAFE-like analogy is a naked warrant; an option to purchase stock of the issuer at a set price at some future date. If you imagine that the strike price of the warrant is well above the current price of the stock, you can see that the warrant is functionally similar to the SAFE: it is an instrument that might turn into equity at some future date – or might not – and has no other claim on the issuing company’s (or any other entity’s) assets.
Now, the thing about naked warrants is that a group called FASB (the Federal Accounting Standards Board) has decided that they should be accounted for as equity. And when FASB speaks, GAAP (Generally Accepted Accounting Principles) listens. And GAAP rules the accounting roost.
Unfortunately, FASB has not gotten around to saying anything about SAFEs as such. Maybe they (quite reasonably) think the analogy to naked warrants is so obvious and kosher that they don’t have to. In any event, FASB’s silence has opened the door for other regulatory heavy-hitters to weigh in on the topic. In this case, the good folks at the SEC (Securities and Exchange Commission) have chimed in.
In the SEC’s view, SAFEs, are better thought of as debt than equity, and should thus be carried as debt on the balance sheet. I won’t bore you with their reasoning, which most folks (including most accountants) find dubious at best. Suffice to say, to the extent it is solid, the SEC’s SAFE reasoning would apply to naked warrants, as well. Which, as discussed, FASB/GAAP have definitively said are accounted for as equity.
Truth be told, the direct impact of the SEC’s take on SAFE accounting is not particularly significant. That’s because SEC reporting requirements generally only apply to publicly traded companies. Those companies, as a rule, are well beyond the stage of life where they would have any reason to issue SAFEs, or have any SAFEs outstanding. A classic no harm, no foul scenario.
Alas, recent changes to SEC offering requirements – ironically, changes designed to make it easier for startups and other less mature firms to raise capital from less sophisticated investors – include provisions that firms that take advantage of those rules will thenceforward be SEC reporting companies, and thus required to periodically report their financial statements to their investors. Financial statements that comply with the SEC’s ideas about accounting treatment of various securities, including SAFEs.
So now we have a problem. When a young, private company asks their professional advisors how to account for SAFEs, what answer should they get?
On the one hand, if you apply GAAP principles (the “P” in GAAP, remember, stands for “principles”), the answer seems clear enough: SAFEs are equity. On the other hand, FASB has not directly addressed the SAFE accounting issue, so as obvious as it may seem that SAFEs should be treated as equity under GAAP the issue is not entirely black & white. And now comes along a powerful federal regulator in the form of the SEC suggesting that absent any actual GAAP rule directly addressed to SAFES it believes that SAFEs should be accounted for as debt.
And so, when your startup client asks you “how do I account for SAFEs” what does the self-respecting professional advisor say? I don’t know? That depends on who you ask? Probably equity, but until FASB actually says so maybe debt? It reminds me a bit of the old saw where various candidates for an accounting position are asked what a column of numbers add up to. The winning candidate’s answer: “How much do you want it to add up to?”
There are two solutions to this conundrum. First, the SEC could come to its senses and acknowledge that contrary to its initial thinking SAFEs should be accounted for as equity. Hmmmm. I am not optimistic. Second, FASB could jump into the breach and declare that SAFEs should be accounted for as equity. I am a bit more optimistic on that score. But, only cautiously so.