Finding investors for your early-stage startup can feel particularly challenging. When you’re working with what might amount to little more than a good idea and a basic product, it’s hard to quantify. And yet, so much of startup financing hinges on getting a valuation for the company. On the other hand, if an option is in place and the bondholders do not exercise this, the company pays the bondholders the principal owed on the debt.

Breaking down accounting for convertible debt issuers

This ‘host debt component’ is therefore classified as a financial liability in its entirety because, on a standalone basis, it does not include a feature that is similar to equity. The fair value of the liability component is $9,400 which is the sum of the fair value of the debt host contract ($9,500) and the non-separable embedded derivative asset ($100). The equity component would therefore be the residual, i.e. $600 ($10,000 less $9,400).

Summarizing Convertible Debt Accounting Complexities

The first investor gets a KISS note for offering you with $100,000, with a valuation cap value of $1 million and a discount rate of 10%. The second investor agrees to offer you a SAFE of $200,000, with a valuation cap of $2 million and a discount rate of 20%. The third investor agrees on offering you a $300,000 SAFE with a valuation cap of $2 million and a discount of 20%.

The FASB’s Investor Educator Video

• A “convertible security” is a financial instrument, usually a bond or preferred stock, that can be converted into a specified number of shares of the company’s common stock at the option of the holder.
• The preceding paragraph also includes conversions pursuant to amended or altered conversion privileges on such instruments, even though they are literally provided in the terms of the debt at issuance.
• This article would help you understand all about convertible notes and the typical convertible note terms.
• The most appropriate approach depends on the specific instrument features and company circumstances.

Proper accounting for convertible bonds under GAAP or IFRS standards requires determining the equity and liability elements. The residual method is an appropriate technique as it allocates value based on the difference between proceeds and discounted cash flows. This is the one of the most common ways to have the conversion triggered. It is normally a set amount negotiated in the convertible note that sets a limit within the next equity financing round. The main idea is to first protect the investor and next to allow the company to gain a significant amount of cash in their equity round without having to deal with the complication of issuing additional shares. These journal entries are a simplified example of the accounting treatment of a convertible note.

But one of the most popular ways of raising funds is by offering investors convertible notes, especially if the company is a startup or during the early stages of development in a company. Using a convertible note, the investor would loan money to the startup, and in return, they would get an agreement to get paid the principal amount (plus an interest) with an option for future equity in the company. No part of the proceeds received is recorded as equity at the time of their issuance because it is difficult to predict when, if at all, the actual conversion will occur.

Convertible Note vs Equity – Which one is right for you?

Since the convertible bonds have features of both liability (debt) and equity, it makes more sense to account for the liability and equity portions separately. Among other requirements, this guidance requires specific criteria to be met in order to qualify for equity classification. The new standard removes certain of these specific criteria and clarifies another criterion. However, the new standard does not amend the scope of specific guidance which requires certain freestanding instruments to be reported as liabilities and mark-to-market accounting for certain instruments (ASC 480). In accounting, it is very important to recognize both elements into the financial statement. The financial liability will initially measure by using discounted cash flow of interest payment and bonds nominal value.

So the cash coming in from your convertible note will generally equate to the liability that you add to the balance sheet. And, if your accounting is doing a good job, the accrued interest is a non-cash expense that flows through your income statement and impacts your accumulated net income in the equity section. Continuing down the right hand side of the above flow chart, we then consider whether the instrument has any characteristics that what are accrued expenses and when are they recorded are similar to equity. The answer is ‘yes’ because the instrument contains an option to be converted into equity instruments, but the question of whether the conversion feature meets the criteria to be classified as equity is dealt with separately in Step four below. This means when the down round feature is triggered, the effect should be treated as a dividend and as a reduction of income available to common stockholders in basic EPS.

All in all, convertible notes are a great way to obtain funding from an investor without having to make any major decisions about your company’s equity at the initial stages. Once your company has reached a good place and is entering another equity round, that is when you can pay off the investor for the convertible note offered. From the above, you can see that the ownership amounts of the common shares, preferences shares and options change. Initially, the ownership of the common shares, preferred shares and options were at 52.63%, 26.32%, and 21.05% respectively. But after the new funding round came in, they have changed to 20.39%, 10.20% and 8.16% respectively, being diluted by the three convertible notes, new option pool and new investment round.

It will also help you get an idea of the value that your company has and how much control you still have over it. Let us assume that a company – XYZ Inc raised its first round of $50,000 from an investor – Tom in exchange for a convertible note with a 20% discount to the Series A round. During the Series A round, the company was valued at $10M with $10 per share price. It is important to know when and why companies would use convertible notes. Let us assume that you have an awesome idea and you need an investor to help you in building that idea into a business. It would be really hard for you to issue stock to the investor since there is no real way to give the stock value.