Some Weird Accounting

Accountants interpret things in very different ways sometimes even when confronted with the same GAAP standards.

For example, as a VC I like to value firms in my portfolio based on negotiated term sheets.  If there is a funding round, that’s the value of the company.  Especially if there are co-investors or if I didn’t lead the round.  If it’s been a couple of years since a round has been executed, there are other metrics you can look at to try and get a valuation but until that next round is in the books it’s awfully hard to mark up a company.

The same sort of thing goes for instruments used to fund startup companies.  There are basically four ways to do it:

1. Debt
2. Convertible Debt
3. SAFEs
4. Priced rounds of equity

Virtually no one uses straight debt at seed.  Or, if they do that’s just not an intelligent way to fund the company.  That leaves the last three.  I heard about a tax wrinkle with convertible debt and I am merely tossing it out into the blogosphere to see what people think.

When you do a convertible debt note, there is an interest rate attached to it.  Typically it’s 8%-10%.  As the Federal Reserve increases interest rates, the rates on notes should go up to reflect the increased cost of capital and the risk associated with investing in a startup.

There is usually a discount of 20% on conversion of the note, and hopefully there is a cap.  There is also a time period associated with the note that doesn’t come into play when you use a SAFE.  I never invest in uncapped notes or SAFEs.  Ever.  No risk/reward there but that’s for another time.

An accountant determined that the interest paid on the note creates a taxable event.  Meaning, if you are a company that issued convertible debt, you have to issue 1099’s to your investors on the interest they earned.  Those investors owe tax on it.

I have invested in capped convertible notes in the past and had never heard of this before.

It makes me wonder if SAFEs, because there is an interest rate component to a SAFE, have the same tax treatment.

I don’t know if this accountant is correct or not.  It’s brand new to me and I have been startup investing since 2005.   If they are right I doubt if a lot of entrepreneurs went through the trouble of issuing 1099s to each of their investors. There are probably a lot of back taxes that investors owe.

Just another reason I prefer priced rounds of equity.