Start-up entities face significant challenges, and one of the biggest is finding and acquiring funding. Up until the time that the entity is able to issue preferred equity instruments, there are other mechanisms for funding purposes.
The most common is a convertible note. Typically, these notes are issued with a stated interest rate and a maturity date; however, they also contain a stipulation that allows for the conversion of the principal and interest into the next round of funding at a discount. The discount can vary, but it usually is anywhere from 15% to 25%. While convertible notes are extremely helpful in securing “bridge” financing between equity rounds, oftentimes the accounting for the loans can be overlooked.
As a complex financial instrument, convertible notes are first analyzed under Accounting Standards Codification (ASC) 470, Debt, and then are generally analyzed under ASC 815, Derivatives and Hedging. One of the most complex areas relates to determining whether or not a component of the principal balance should be bifurcated and allocated to equity.
Another financial instrument that start-ups often use is a Simple Agreement for Future Equity (SAFE). These agreements are popular because they typically do not have maturity dates and are not required to be repaid. SAFEs usually only convert upon a triggering event outlined in the SAFE. The classification is intricate as a result of the characteristics of the SAFE, and there has been significant debate on the classification between debt and equity as it relates to SAFEs.
While both types of instruments bring value to the entity in between equity rounds, it is important to not forget about the complex accounting rules that must be applied to these types of agreements.
Schneider Downs has the expertise to assist in the accounting for these types of instruments. Contact a member of our Emerging Technology Services Group or our Accounting Advisory Services Group for further information.
About Schneider Downs Emerging Technology Services
Schneider Downs understands the ever-changing landscape and business challenges facing companies focused on emerging technologies and software. Our clients represent a wide range of organizations, from emerging growth companies to large mature companies, and we are well versed in the unique challenges they face. Our team of seasoned professionals has experience working with emerging technology companies in all phases of their evolution.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.