Hungarian venture capital investors are increasingly investing in American companies through “SAFE” agreements, which have revolutionized the capital raising process for early-stage startups. In many cases, this is done to finance Hungarian startups operating under US parent companies. Due to the hybrid and innovative nature of this financing means, accountants of concerned Hungarian investors ponder in May each year whether they have recorded the SAFE investments on correct lines and with correct numbers in the balance sheet.
In our collaborative blog post with CSŐVÁRI LEGAL, specialized in transactional legal and tax services for technology companies, we present the essence of SAFE agreements and some fundamental accounting and taxation issues related to them.
In the startup world, access to timely financing is crucial for the birth and survival of new ventures. However, in the early stages, founders face challenges beyond finding willing investors. They must contend with the time and cost involved in the legal investment process, their own inexperience in negotiation, and the valuation of their companies.
To address these obstacles, Y Combinator, a renowned American startup accelerator, developed and popularized the Simple Agreement for Future Equity (SAFE) a decade ago. This standardized investment contract template has revolutionized the capital raising process for startups.
Unlike traditional equity or convertible bond investments, where investors receive shares or bonds at the time of investment, SAFE agreements grant them the right to receive shares at a later stage, during subsequent rounds of capital raising or conversion events. The latter may include company sales, IPOs, changes in control rights, or liquidation. By simplifying the investment process during the early stages, SAFE agreements help avoid significant transaction costs, and of course save precious time.
Another innovative aspect of SAFE is the deferral of the final determination of the conversion price for the shares acquired through financing. Within predefined limits, the conversion price is based on the valuation established during the first standard capital raising round, typically seed or series A, with adjustments made according to predetermined correction factors outlined in the SAFE agreement. This approach alleviates the burden of valuation issues for founders and early-stage investors, as subsequent standard fundraising rounds will establish the evaluation for them too.
Ideally, SAFE financing ultimately results in equity shares. However, there are scenarios where partial or full repayment of the investment may occur, or the investment may be entirely lost. Repayment typically takes place when the funded company is liquidated without a conversion event, granting SAFE investors the right to liquidation proceeds before common stockholders.
Coming to America
While SAFE agreements are primarily used to finance US-based companies, their usage is gradually expanding to other countries with developed capital markets. Hungarian startups can indirectly receive capital through SAFE agreements via their American parent companies, as has often been the case, including with investments from Y Combinator itself. In such cases, SAFE agreements do not raise any legal, tax, or accounting concerns in Hungary.
However, Hungarian venture capital funds, angel investors, and other investors are increasingly investing in US companies using SAFE agreements, with these US companies frequently holding Hungarian startups the investors aim to indirectly finance. These Hungarian investors inevitably face the uncertainties surrounding the accounting and tax treatment of SAFEs, which are entirely foreign to the Hungarian legal system. Such uncertainties can also impede the Hungarian adoption of this innovative and globally proven investment form.
Due to its multifaceted and unconventional nature, the classification of SAFE investments as either equity or debt presents a fundamental dilemma for accounting practices worldwide. This question also troubled US accountants for some time in the past. Eventually, the issue was decided by declaring that it cannot be decided just like that: each individual SAFE investment needs to undergo specific tests to determine whether they meet the criteria for equity investments according to US accounting standards.
Hungarian accounting regulations interpret capital investments more conservatively than the US, only recognizing what the owner/member has directly provided to the company, as equity on the investee’s side, and as equity interest on the investor’s side. Therefore, SAFE financing should be treated as a receivable and recorded as “other receivables” until the SAFE position is closed. When the SAFE agreement concludes with a share conversion, equity interest is typically recorded in the receivable’s place, with a value aligned with the book value of the receivable. This valuation is independent of the conversion price, SAFE-based correction factors, or the actual market value of the startup. Depending on the intention to hold the shares in the short or long term, the equity interest should be presented in the balance sheet as an invested financial asset or among current assets. Importantly, a share conversion itself does not impact the income statement and does not have tax implications.
In principle, receivables should be revaluated at the end of each fiscal year. In cases where full repayment is unlikely, an impairment loss should be recognized. However, evaluating the “unlikeliness of repayment” for startup investments, particularly at early stages, is problematic due to the inherent high risk involved. As a result, impairment losses are rarely expected or recognized in practice. If the conversion definitively fails, and the financing is not fully recovered, the resulting loss is treated as bad debt and accounted for as “other financial expenses.” This realized loss is tax-deductible and can offset taxable income from other transactions.
Timing and manner of conversion
… are also relevant when considering tax consequences. The primary goal of every SAFE investment is to eventually sell the acquired shares at a significant profit. For Hungarian corporate shareholders, capital gains from such sales can be tax exempt if the shares are held for a minimum of one year. It is essential to note that the holding period for SAFE investments begins at the acquisition of the shares, not at the signing of the SAFE. As a result, the Hungarian tax treatment of capital gains on shares depends on the timing and triggering event of the conversion. For example, if the conversion is associated with a company sale, which also involves immediate sale of the converted shares, it is impossible to fulfill the holding period requirement and realize tax-free gains. Therefore, compared to traditional capital investments involving immediate and direct share issuance, SAFE investments can potentially create additional tax burdens for Hungarian corporate investors, often due to circumstances beyond their control.
Given the current lack of settled Hungarian accounting practices, it is crucial to acknowledge the possibility of different accounting and tax interpretations. Additional factors to consider include potential US withholding tax issues related to dividends from SAFE-based shares, especially in light of the termination of the US-Hungarian tax treaty, as well as the income tax implications for individuals entering into SAFEs.