Tech startup accounting

Financing arrangements can be complex as a result of specific terms within a debt instrument or the issuance of other instruments along with a debt instrument. Accounting rules for financing arrangements can be difficult to apply, and recognition and measurement of derivative instruments and classification of equity-linked instruments as debt or equity continue to be frequent sources of financial statement restatements.

Debt instruments issued by technology startups commonly include features that allow or require conversion or repayment of the debt upon the occurrence of a contingent event, such as the borrower obtaining equity financing or a change in control of the borrower. Such redemption features often provide for settlement of the loan at an amount that exceeds its principal and accrued interest (at a premium) to compensate the lender for interest foregone due to early payment of the debt or to provide the lender with upside in the event the company’s stock price increases to above a specified level. However, understanding the substance of the agreement’s terms and conditions can be challenging.

For example, technology startup companies frequently issue convertible debt that allows or requires the investor to convert the debt into a “next round” of shares issued upon the occurrence of a future equity financing, often at a discount to the next round’s share issuance price. While the feature may be labeled as a conversion feature, it often economically represents a redemption feature – that is, a variable number of shares may be used as currency to deliver a fixed economic value to the investor in settling the debt. In this instance, the embedded feature might require accounting evaluation as a redemption feature rather than a conversion feature, which might result in derivative accounting being applied to the feature.

Lastly, technology startups commonly issue debt with detachable warrants. The inclusion of warrants in the financing arrangement might allow the company to obtain a lower coupon rate on the debt by providing the lender with upside in the event the company’s stock price increases above a specified level. However, warrants often contain myriad terms and features that can pose accounting challenges, such as adjustments to the number of underlying shares or exercise price upon specified events, put options, settlement in a variable number of shares with a fixed monetary value, and other settlement features that might require careful analysis.

Financial reporting considerations

Redemption features and conversion features embedded in debt instruments must be evaluated to determine if they require separate recognition from the debt agreement as a derivative, which can be a complex assessment and might require considerable judgment. If separate recognition is required, the financing proceeds should be allocated between the debt and the derivative, with the derivative being initially and subsequently measured at fair value at each reporting date. Additionally, the inclusion of warrants in a financing arrangement requires the financing proceeds to be allocated between the warrants and the debt instrument. This proceeds allocation often results in the debt instrument being issued at a discount, which might require derivative accounting to be applied to certain embedded features, such as redemption features, that wouldn’t ordinarily require derivative accounting if the debt was issued at par. Further, warrants must be analyzed for classification as a liability or equity. Liability-classified warrants are initially and subsequently measured at fair value each reporting period, while equity-classified warrants are initially measured at fair value (or relative fair value if issued with other free-standing instruments such as debt) and typically are not subsequently remeasured.

The requirement to measure derivative instruments and liability-classified warrants at fair value adds another layer of complexity, which might necessitate the involvement of a third-party valuation specialist.

Many other embedded contract terms in debt instruments can trigger derivative accounting. Before entering into a debt financing, company management should consider features such as conversion and redemption terms, especially those that are contingently exercisable, such as a debt holder’s ability to acquire a variable number of equity shares at a substantial premium or discount, early repayment premiums, interest make-whole provisions, and other settlement options that enable the investor to settle the debt at a substantial premium.

Embedded features in tech startup financing arrangements can be complex, and many nuanced variations of similar features exist in practice. A careful review by qualified accounting professionals can reveal whether such terms would trigger the need to apply derivative accounting or the substantial premium model in ASC Subtopic 470-20, “Debt With Conversion and Other Options.”

Another popular alternative financing instrument for tech startups is a simple agreement for future equity (SAFE). Unlike convertible debt, a SAFE is not a loan and has no interest, no payments, and no maturity date. In addition, a SAFE generally does not provide the investor with voting rights or other rights of ownership, and unlike other equity-like instruments, it represents neither an option nor an obligation to purchase equity. Rather, it is simply a contract that provides the investor a right for their present cash investment to be converted into equity at some point in the future when an agreed-upon equity financing event happens, while providing other settlement options if, for example, a liquidity event or dissolution of the entity occurs before a future equity financing takes place.

In addition to defining triggering events such as a future equity financing, SAFE contracts often give investors a discount off the price other investors would pay at the time of the triggering event. Many also include a valuation cap that defines a maximum number of shares the investor would be entitled to at the time of conversion.

Financial reporting considerations

A critical question management must decide when entering into a SAFE contract is how to account for it on the company’s balance sheet. At the most fundamental level, the infusion of cash is obviously recorded as an asset. But what sort of entry offsets that asset on the other side of the balance sheet? Should the SAFE contract be recorded as a liability or as part of the company’s equity?

Because a SAFE contract does not contain typical debt instrument characteristics such as an interest rate or payments, companies often assume the SAFE contract represents a right that should be classified as equity. However, the classification can vary, depending on how the agreement is written, and the analysis of the contract can be complex. U.S. GAAP has specific, detailed guidance in this area, as published in ASC Topic 480, “Distinguishing Liabilities From Equity.” Among the criteria used to determine classification are whether the instrument embodies an obligation to repurchase the issuer’s shares or is indexed to such an obligation and whether the issuer might be required to settle the obligation by transferring assets. For instance, a SAFE that can require the issuer to pay cash to the investor upon occurrence of certain events or at a certain point in time might be required to be recorded as a liability, which requires the entity to measure the instrument initially and subsequently at fair value. However, a SAFE that might result only in the issuance of the SAFE issuer’s shares might qualify for equity classification if the contract passes through additional indexation and equity classification tests in ASC Subtopic 815-40, “Contracts in Entity’s Own Equity.” If the SAFE contract fails to pass either of those tests, then the SAFE will be accounted for as a liability measured initially and subsequently at fair value, and derivative disclosures might also be required.

SAFE instruments recorded as equity are not subsequently remeasured. On the other hand, SAFE instruments classified as liabilities are remeasured at fair value each reporting period. A company can incur additional time and expense each year in determining the fair value of the SAFE, which could require engaging a third-party valuation specialist.

Another major challenge for many tech startups is the need to attract and retain talent in a tight market, particularly when the company has only limited cash flow available. Offering an equity stake, either immediately or in the future, can be a powerful recruiting tool, with the added benefit of incentivizing employees to focus on performance and adding value to the organization.

Financial reporting considerations

Although the financial reporting complications associated with these offerings are sometimes a little simpler than those arising from some equity financing arrangements, they nevertheless should be considered when company management sets up such programs.

Equity compensation arrangements can be structured in various ways. Among the most straightforward are outright grants of shares of stock or restricted stock, which allow employees to gain an ownership stake in the company once they have worked for a specific duration or achieved certain performance targets.

Stock options, on the other hand, become equity in the company when employees exercise their options to purchase shares once the options are vested. Vesting provisions – such as time vesting or achieving performance targets – are spelled out in the grant, as are various other details. Other common option terms include a specified exercise price, option expiration dates, market conditions, and any required waiting period before an option holder can resell any stock acquired.

While many companies are familiar with accounting for stock or stock option grants, another form of equity compensation that is prevalent in pass-through entities, such as partnerships or limited liability companies, is a profits interest grant. Profits interests are a special class of equity in a pass-through entity that provide a vested grantee an opportunity to participate in distributions of future profits and/or appreciation in the net assets of the issuing entity (but not existing capital). Profits interests are complex arrangements to account for because: 1) they can feature a variety of different terms and appear similar in form to stock options, stock appreciation rights, restricted stock, or profit-sharing arrangements, to name a few, and 2) U.S. GAAP does not provide explicit guidance covering the scope and accounting for profits interest awards. When evaluating the accounting for profits interest awards, management needs to consider all relevant terms and features of the award to determine whether the instrument represents a substantive class of equity. Profits interest awards that represent a substantive class of equity are accounted for under ASC Topic 718, “Stock Compensation,” and might be classified as equity or a liability based on specific classification guidance in Topic 718. On the other hand, profits interest awards that are not a substantive class of equity typically are accounted for as a performance bonus or profit-sharing arrangement pursuant to guidance in ASC Topic 710, “Compensation,” and classified as a liability.

Determining the scope and accounting for profits interests can be complex and requires judgment. Often, the analysis focuses heavily on what happens to a vested award when the grantee voluntarily terminates employment. That is, do grantees that terminate employment maintain the right to keep the vested award and participate in distributions regardless of employment status, or do they lose their right to benefit from the award – through either forfeiture or a company-controlled call option at a nominal value? Settlement terms also typically factor into an entity’s analysis of a profits interest award. For example, some awards permit or require settlement at fair value, while others might settle at an off-market or formula value. Likewise, some awards explicitly require cash settlement, while others are silent or provide the entity with the ability to control whether the award is settled in cash or equity. In some cases, profits interest awards that are accounted for under ASC 718 and would otherwise be classified as equity might still require liability classification, either initially or subsequently, if the issuer demonstrates a past practice of cash settlement of such interests within six months of vesting.

Companies that offer equity-based compensation arrangements sometimes overlook the accounting implications, believing that there is no need to recognize the award on the financial statements. This might be because there is no cash implication at issuance, because the award is not in the money at issuance, or even because the award will not be monetized until it is settled, which might not happen until there is a change in ownership. To be GAAP-compliant, however, companies should recognize that employees who are granted equity-based awards receive something of value at the time of the grant in exchange for the employee’s service, and the company should record an appropriate expense over the requisite service period if those options probably will vest in the future.

Again, the critical question is whether the option should be recognized as an equity item or a liability. If a share-based payment is classified as equity, it is measured at its fair value on the grant date and recognized as compensation cost as it is earned. Depending on how the company structures the award, however, it could be classified as a liability, in which case it would need to be revalued each reporting period until it is settled. This often is the case when awards include an employee-controlled redemption option (that is, a put option); when companies have a history, based on relevant facts and circumstances, of cash-settling options or immature shares (that is, within six months of a share becoming vested); or when awards provide for off-market settlement.

As a practical matter, when tech startups are contemplating the use of convertible debt, SAFEs, or share-based compensation to address financing or recruiting challenges, the potential accounting and financial reporting complications should not be the driving factors in their decision-making. Nevertheless, it is important for tech company management teams to be aware of these tools’ accounting implications and understand how such arrangements could produce unforeseen consequences in the future. Above all, they should not hesitate to reach out for qualified guidance as they structure and fine-tune the details of their equity offerings.