Look carefully before choosing “simple” venture financing alternatives

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Observations from the front lines 

Background

  • Early stage companies are increasingly focused on capital sources with more flexibility, less complexity and fewer transaction costs.
  • While traditional seed equity and preferred stock financing structures continue to be an important source of funding, many pre-IPO companies also seek more streamlined and cost-effective solutions to raise capital between equity rounds. As a result, a range of standardized “bridge” financing alternatives have emerged.
  • Utilizing standardized bridge financing terms helps streamline negotiations with investors and reduce costs. However, while the potential advantages may be attractive, issuers should be aware of the potential for increased balance sheet and income statement volatility.
Debt vs. equity financing

Why it matters

Many development-stage companies require bridge financing. Increasingly, they are being drawn to standardized instruments, such as Simple Agreements for Future Equity (SAFE) and Keep It Simple Securities (KISS). However, the accounting, legal and operational details associated with these arrangements are not always straightforward, despite what their names may imply. While the instruments may be labeled “equity” or may entitle the investor to an equity-like return, they may not result in equity classification and measurement for accounting purposes.

Typical economic characteristics

Financing alternatives

SAFEs

Some variations exist but common features include:

  • Investor makes up-front payment in exchange for the right to future preferred shares issued by the company in the next equity financing, typically at a discount (e.g. 20%) to the price paid by other investors in the next round of financing.
  • No interest coupon or contractual maturity.
  • May contain a company valuation cap that provides a floor for the number of shares the investor may receive on conversion.
  • Upon a liquidity event (i.e. change of control or IPO) prior to next equity financing, the investor receives cash or common stock of the company at a discount to the price in the liquidity event or at the valuation cap.
  • Provides a preference in liquidation equal to the invested capital.

May include a “most favored nation” clause where the investor can elect to replace the SAFE with a convertible security issued by the company with more favorable terms.

Convertible promissory notes and similar instruments1

Numerous variations exist but common features include:

  • Investor makes up-front payment for the instrument.
  • Typically carries a stated interest coupon and has a contractual maturity date.
  • The instrument converts upon next equity financing, either automatically or at the investors’ option, typically at a discount (e.g. 20%) to the price paid in that equity financing, with the conversion price sometimes subject to a floor (a valuation cap).
  • In the event of certain corporate transactions, the investor can elect to either redeem – sometimes at a multiple (e.g., 2x of the principal amount) plus accrued and unpaid interest – or convert into company stock.
  • At maturity the company may be required to repay the principal and accrued but unpaid interest, or the investor may have the option to convert to shares or redeem, or else the instrument remains outstanding until the company decides to call (perhaps at a premium) or the investor chooses to convert or redeem.
  • May include a “most favored nation” clause where the instrument is amended for more favorable terms if the company subsequently issues an instrument with those terms.

1The debt and equity version of KISS contains many of these same features.

Venture financing

A closer look at the accounting

When evaluating the accounting for these types of financing alternatives, issuers should consider the guidance applicable to financial instruments that are not issued in the form of outstanding shares.

Liability classification, and generally mark-to-market accounting, is required in the following situations:

Application to SAFEs and convertible promissory notes and similar instruments:
Instruments that are issued as legal form debt, while not necessarily required to be marked-to-market, are liabilities of the issuer. Instruments that are not marked-to-market are required to be assessed for the existence of embedded derivatives.

Convertible promissory notes are legal form debt and recorded as a liability of the issuer.

Instruments that contain an obligation for the issuer to repurchase shares (or are indexed to such an obligation) and require (or may require) the issuer to transfer cash or other assets on such settlement (e.g., forward contract to buy back shares, a written put option on shares, or a written call option on redeemable shares). Instruments that allow the holder to receive shares on exercise or put the instrument in exchange for cash or other assets, even if only on certain contingencies, and that are indexed to an issuer’s stock price, are generally liabilities (for example, puttable warrants). SAFEs often embody a conditional obligation to transfer cash or other assets upon certain contingent events (e.g., IPO or change of control) and are also indexed to the issuer’s own equity, resulting in possible liability classification and mark-to-market accounting.
Instruments where the issuer must or may settle by delivering a variable number of shares and the value at inception is predominantly based on either:
  1. A fixed-dollar amount (e.g. stock-settled debt),
  2. Something other than the issuer's shares (e.g. indexed to the S&P 500), or
  3. Inversely related to the fair value of the issuer’s shares (e.g., net-share settled written put option).

While SAFEs may require the issuer to deliver a variable number of shares with the value received by the investor equal to the invested capital (prepaid amount) plus a fixed premium, the issuer typically controls the event(s) that may trigger settlement in a variable number of shares (it is not an obligation of the issuer). Consequently, SAFEs may not be liability classified under this criterion.

Even if a freestanding instrument is not a liability due to the criteria above, the instrument can only be classified as equity if it is both: (1) indexed to the issuer's own stock, and (2) eligible for equity classification.

Even if SAFEs are not a liability for one of the aforementioned reasons, they may not meet the requirements for equity classification – for example, due to having rights that rank higher than shareholders of the underlying stock and/or not having an explicit limit on the number of shares issuable on settlement.

The analysis does not stop there

Assuming the instrument is a liability and the issuer does not elect (the fair value option), or is not required, to measure the entire instrument at fair value, convertible promissory notes and similar instruments will require a focused analysis for features that require separate accounting as embedded derivatives (separated and measured at fair value each reporting period). In particular, issuers should analyze their financing structures for features that provide a leveraged return, for example via variable share settlement. A common example is a conversion feature in a convertible promissory note where the note converts into the next financing round at a conversion price that is set at a substantial discount to the price paid by other investors in that next financing round.

The bottom line

Companies seeking to use complex financing arrangements should fully understand the nuances of the arrangement, including the accounting treatment. Contact your PwC advisor for more guidance.

“Observations from the front lines” provides PwC’s insight on current economic issues, our perspective regarding the financial reporting complexities, and what companies should be thinking about to effectively address those issues. For more information, visit www.pwc.com/us/cmaas.

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Morris Jones

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