Convertible Notes and SAFEs: Audit Guide for Startup Clients

Early-stage companies fund themselves with convertible notes and simple agreements for future equity (SAFEs) long before a priced round. By the time the first audit arrives, there can be a dozen instruments with different caps, discounts and side terms, and a management team that recorded all of them as a single line in equity or in liabilities at the cash received.

That treatment needs a term-by-term analysis. This guide covers the accounting questions, the measurement, and the procedures that produce a supportable file.

What each instrument is

A convertible note is debt. It carries principal, usually interest and a maturity date, and converts into equity on a qualified financing, often at a discount or subject to a valuation cap. If it does not convert, the holder can ask for repayment.

A SAFE has no maturity and no interest. The investor pays cash and the issuer agrees to deliver a variable number of shares with a fixed aggregate monetary value later. Grant Thornton describes it as "a variable number of shares with a fixed aggregate monetary value." SAFEs often include settlement terms tied to events such as a change of control or liquidation, and the issuer must apply judgment to decide whether the instrument is a liability or equity.

Convertible notes: the accounting

For notes, start with ASC 470-20 and ASU 2020-06. The ASU removed the beneficial conversion feature and cash conversion models. The models that remain are bifurcation of an embedded conversion feature as a derivative under ASC 815, and convertible debt issued at a substantial premium. For entities that are neither SEC filers nor otherwise public business entities, the ASU is effective for fiscal years beginning after December 15, 2023. A convertible note without bifurcated features is carried as a single liability at amortized cost.

The questions that matter at a startup:

• Is there an embedded derivative? Assess any feature that converts into shares at a discount on a qualified financing, or pays a multiple of principal on a change in control. Those are share-settled or cash-settled redemption features that must be assessed for bifurcation under ASC 815-15 as part of the note.
• Interest and amortization. Recompute accrued interest, discount and issuance cost amortization.
• Classification as current or noncurrent. Maturity dates and extensions drive this, and so does the likelihood of conversion.
• Modifications and extensions. Amendments to cap, discount or maturity can be a modification or extinguishment of debt.

See the standards page on convertible debt and ASU 2020-06.

SAFEs: the accounting

A SAFE is a freestanding financial instrument. The analysis starts with ASC 480, whose scope is broad. KPMG explains that an instrument is an obligation of the issuer if it conditionally or unconditionally obligates the issuer to settle by transferring assets or by issuing equity shares in certain circumstances, and that an unconditional obligation to settle in a variable number of shares, such as a fixed monetary amount settled in a variable number of common shares, is classified as a liability. A SAFE that converts at a price set by a future round or a cap fits that pattern.

Then consider ASC 815-40 for equity-linked contracts, and the ASC 480 standards page.

One SEC filer disclosed that its SAFEs were "classified as marked-to-market liabilities pursuant to ASC 480." The SAFEs allowed cash redemption on a change of control, an event outside the company's control. The SAFEs were marked to fair value as of the settlement date and derecognized at their final carrying amounts, and the preferred shares issued at settlement were recorded at fair value.

When the SAFE is a liability at fair value:

• Initial measurement is at fair value, which is the cash received for an arm's-length SAFE.
• Remeasurement each reporting date runs through earnings.
• The valuation uses inputs the company cannot observe, so treat it as a Level 3 measurement and test the model, the scenario weights and the equity value underlying them. See ASC 820.
• When equity value rises between rounds, the liability increases and the company records a loss.
• On conversion, the fair value is remeasured to the settlement date and then reclassified to the new equity.

Worked example (illustrative numbers)

A startup raises $500,000 on a SAFE with a $5,000,000 valuation cap and a 20% discount. Fully diluted capitalization before the Series A is 10,000,000 shares. The Series A closes at $1.20 per share. The simplified terms below apply the cap to the pre-round capitalization.

If the SAFE was carried at $500,000, the settlement-date remeasurement produces a $700,000 loss. If the company carried it at cost for the year and expensed nothing, the entire loss appears in the conversion period and the prior period is misstated. An auditor who finds this should evaluate whether it is an error under ASC 250, using the stockholders' equity rollforward to see where the instrument sat.

A parallel convertible note: $1,000,000 principal, 6% simple interest, converting after 12 months at a 20% discount to the same $1.20 round. Accrued interest is $60,000. The conversion amount is $1,060,000, at $0.96 per share, giving about 1,104,167 shares, worth $1,325,000 at the round price. The $265,000 excess over the amount converted is the value of the discount feature, which must be considered as part of the bifurcation analysis.

Typical audit procedures

1. Obtain every note and SAFE with all amendments, side letters and most favored nation provisions.
2. Build an instrument schedule: date, amount, cap, discount, maturity, interest, settlement terms.
3. Prepare a term-by-term classification memo covering ASC 480, ASC 815-40 and ASC 815-15.
4. Confirm balances and terms directly with holders where the amounts are significant.
5. Recompute interest, amortization and fair value; evaluate the valuation inputs and model; use an auditor's specialist where the model requires it.
6. Trace conversions to the closing set, the cap table and the stock ledger.
7. Test cutoff: cash received near year end, and instruments signed but not funded.

PBC items

• All notes, SAFEs, amendments and side letters
• Instrument schedule and cap table showing as-converted ownership
• Management's classification memo and fair value model
• Term sheets and closing documents for each financing round
• Bank statements showing receipt of proceeds
• Board minutes approving the instruments
• Legal counsel letter listing outstanding convertible instruments

Red flags

• Instruments recorded in equity with no written analysis
• A SAFE recorded at cost year after year while a priced round is in negotiation
• Missing instruments: funds received with no agreement, or agreements with no cash
• Side letters with change-of-control cash payments
• Related-party investors on different terms than outside investors (see related party transactions)
• Notes past maturity and still classified as long term

Sources

• Grant Thornton, Issuers' accounting for SAFEs (Viewpoint, February 2024)
• SEC EDGAR, Financial statement note on SAFE accounting under ASC 480, filer disclosure of SAFEs as marked-to-market liabilities
• KPMG, Hot Topic: Structured equity transactions (Topic 480 classification)
• FASB, ASU 2020-06, full text on PwC Viewpoint (removed models, remaining separation models, effective dates)

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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error