Before You Start

This guide assumes a strong understanding of balance sheet accounts, particularly liabilities and equity, and basic accounting principles relevant to startups.

Overview

45 min
Accounting Time
Expert
Difficulty
Event-Driven
Frequency

What You’ll Learn

  • How to properly classify convertible notes and SAFE agreements on your balance sheet
  • Recording the initial funding proceeds from these instruments
  • Understanding the accounting implications of their eventual conversion into equity
  • Executing the correct journal entries for various conversion scenarios

1. Understanding the Instruments

Before detailing the accounting entries, it’s crucial to understand the fundamental characteristics of convertible notes and SAFE agreements:

Convertible Note Essentials

  • Definitive maturity date and interest accrual
  • Valuation cap and/or discount applied at conversion
  • Initial classification as debt on the balance sheet
  • Potential for complex embedded derivative accounting

SAFE Agreement Essentials

  • No maturity date or interest accrual
  • Valuation cap and/or discount applied at conversion
  • Initial classification can be liability or equity (highly nuanced)
  • Often simpler initial accounting, but complex conversion analysis

2. Initial Accounting & Classification

You have distinct approaches for convertible notes and SAFE agreements.

Method A: Convertible Notes (Debt)

These are typically classified as debt instruments upon issuance.

Pros:
  • Straightforward initial debt recording.
  • Interest expense is typically deductible.
  • Clear maturity date provides certainty.
Cons:
  • Requires periodic interest accrual.
  • Can involve complex embedded derivative accounting.
  • Impacts debt-to-equity ratios.

Method B: SAFE Agreements (Equity-like)

SAFEs often present more complex classification challenges due to their equity-like features.

Expert Tip: Accounting for SAFEs can be highly nuanced. Depending on specific terms (e.g., liquidation preference, redemption features), they might be classified as liabilities or equity instruments. Consult with an experienced startup accountant to ensure proper classification.

3. Recording the Initial Proceeds

Here are typical journal entries when cash is received from these instruments.

// On receiving cash from a Convertible Note
Debit: Cash (Asset)                $500,000
Credit: Convertible Notes Payable (Liability) $500,000

// To record monthly/quarterly interest expense (Convertible Note only)
Debit: Interest Expense (Expense)     $X,XXX
Credit: Interest Payable (Liability)  $X,XXX
// On receiving cash from a SAFE Agreement
// Classification depends on specific terms. Common options:

// Option 1: Classified as a Liability (more common for complex SAFEs)
Debit: Cash (Asset)                $250,000
Credit: SAFE Liabilities (Liability) $250,000

// Option 2: Classified as Paid-in Capital (Equity) (for simpler SAFEs)
Debit: Cash (Asset)                $250,000
Credit: Paid-in Capital (Equity)     $250,000

4. Accounting for Conversion Events

  1. 1

    Identify Conversion Trigger

    Determine the specific event that triggers conversion, such as a Qualified Financing (e.g., a Series A equity round) or a Change of Control.

  2. 2

    Calculate Conversion Shares

    Determine the number of shares of equity (e.g., Preferred Stock) to be issued. This requires applying any agreed-upon discounts or valuation caps to the equity round price, using the method that yields more shares for the investor.

  3. 3

    Accrue Final Interest (Convertible Notes Only)

    Ensure all accrued interest on convertible notes is recorded up to the exact date of conversion before making the final reclassification entry.

  4. 4

    Execute Conversion Journal Entries

    Reclassify the original liability (and any accrued interest for notes) into the appropriate equity accounts (e.g., Preferred Stock, Paid-in Capital).

Critical Consideration: Valuation Caps & Discounts

When a conversion event occurs, you must calculate both the discount price and the valuation cap price (if applicable). The investor will convert at the lower of these two effective prices, which can significantly impact the number of shares issued and the dilution for existing shareholders.

5. Post-Conversion Review

Conversion Checklist

  • Confirm conversion calculations are accurate based on agreement terms
  • Verify the original liability (and accrued interest) is fully derecognized
  • Ensure new equity (e.g., Preferred Stock and Additional Paid-in Capital) is correctly recorded
  • Update the company’s capitalization table to reflect new share issuance
  • Adjust disclosures in financial statements for the conversion event

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