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Why accounting for SAFE notes in Australia is anything but simple
SAFE notes (simple agreement for future equity) are a type of investment instrument, commonly used by startups to raise early-stage funding.
SAFE notes are common in the United States of America (USA) and their use in Australia is increasing as founders seek flexible alternatives to traditional equity raising and the use of convertible notes or other early-stage financing arrangements.
However, the accounting treatment for SAFE notes is different in Australia than it is in the USA. The additional layers of complexity can create confusion for those responsible for financial reports.
What is a SAFE note?
A simple agreement for future equity (SAFE) is an agreement between an investor and a company, that gives the investor the right to receive equity in the company at a future date, either at a fixed date, or, more commonly, when one or more specified trigger events occurs.
Key features of SAFE notes
1. Conversion to equity
SAFEs typically convert into shares when a triggering event occurs. Examples of a triggering event can include; a capital raise, a business sale, merger or acquisition or initial public offering.
2. Terms of conversion
SAFEs have a range of different conversion terms. Some have a fixed conversion price. However, more commonly they have a ‘cap’ and/or a ‘floor’ price.
Valuation cap: Sets the maximum valuation at which the SAFE will convert, protecting early investors from excessive dilution.
Discount: Allows SAFE holders to convert at a lower price than new investors in the next round.
Accounting for SAFE notes for financial reports in Australia
While SAFEs may simplify initial funding, they introduce complexity in financial reporting. SAFEs typically have some of the characteristics of equity, such as no interest, and no fixed maturity date. However, the terms for their conversion into equity are often complex and multi-layered, which may create uncertainty about their classification within the financial report
- should they be shown as a financial liability?
- or as equity?
- are they a form of derivative?
- how do changes in the terms affect the classification?
Entities operating globally may be familiar with the treatment and classification of SAFEs in the USA, where the concept originated. However, the treatment of SAFEs under IFRS, or under the IFRS-equivalent Australian Accounting Standards, is significantly different to the treatment under US GAAP. As a result, entities operating in multiple jurisdictions may need to perform a separate assessment under each framework.
Applying the ‘fixed for fixed’ test
Many issuers, and promoters, of SAFEs assume they should be classified as equity, given that they will, at some point, convert into shares.
However, the treatment of SAFEs is governed by AASB 132 Financial Instruments: Presentation. To be classified as equity in its entirety, it requires a SAFE to meet two tests:
- There must be no contractual obligation to deliver cash.
- There must be no contractual obligation to deliver a variable number of equity instruments.
This is commonly known as the ‘fixed for fixed’ test, as it requires the exchange of a fixed number of shares for a fixed consideration.
Example 1:
An entity issues a SAFE Note for consideration of $1m. The note converts into 1 million shares at the earlier of an IPO, a significant capital raising event, or five years.
There are no circumstances under which the Note would be repayable in cash.
This note involves the issue of a fixed number of shares for a fixed amount of cash, and therefore the entire balance can be classified as equity at inception. It is never subsequently remeasured.
However, the above form of SAFE is relatively uncommon. More typically, SAFEs include features such as valuation caps or conversion rates based on discounts to the price achieved. It is also common for there to be multiple different conversion features which may be interlinked with each other. In these circumstances, the ‘fixed for fixed’ test is usually not met, resulting in the arrangement being classified as a derivative financial liability under AASB 9 Financial Instruments.
Example 2:
An entity issues a SAFE Note for consideration of $1m. The note converts into shares at the earlier of an IPO, a significant capital raising event, or the sale of the business. There are no circumstances under which the Note would be repayable in cash. The conversion price will be a 20% discount on the share price in the transaction which gives rise to the conversion, capped at a maximum of $3 per share.
This note involves the potential issue of a variable number of shares in return for a fixed amount of cash. It therefore fails the ‘fixed for fixed’ test. Since there is no obligation to deliver cash, the entire SAFE is a derivative financial liability representing the right to a variable number of future shares.
As such, it should initially be recognised as a financial liability of $1m, and then subsequently fair valued at every reporting date, with any increase or decrease in that fair value being reflected as a profit or loss in the income statement.
What happens to a SAFE on liquidation?
SAFEs are typically issued by start-up entities, meaning that they are often high-risk in nature. Holders of SAFEs should consider what rights they would hold in the event of the liquidation or insolvency of the issuer of the SAFE. Their position will depend on the nature and terms of the contractual arrangement for the SAFEs, but typically SAFEs rank below all other creditors in the event of liquidation, albeit ahead of ordinary shareholders. Accordingly, any return to investors holding SAFEs in an insolvency scenario is highly unlikely.
How can RSM help with SAFE notes?
RSM can help businesses navigate the complexities of SAFE note accounting by providing expert guidance on the accounting classification, valuation, and compliance. Our team can help ensure that SAFEs are correctly recognised and disclosed in financial statements in accordance with accounting standards.
We are also happy to discuss proposed transactions to determine whether the accounting treatment on execution will be in line with management’s expectations.
