Classification of convertible notes and SAFE instruments as liability or equity

Convertible notes and SAFE instruments common in early-stage fintech fundraising rarely meet the fixed-for-fixed criterion for equity classification because conversion terms typically depend on a future variable-priced funding round, valuation cap, or discount, meaning the instrument (or an embedded conversion feature within it) is frequently classified as a financial liability measured at fair value through profit or loss, causing significant income statement volatility as the fair value of the conversion right changes; misclassifying these as equity can materially understate liabilities and mislead readers about leverage.

Does the number of shares issuable on conversion vary with a future financing round's price, a valuation cap, or a discount, rather than being fixed at inception (failing the fixed-for-fixed test)? Does the instrument include any redemption right that could require cash settlement, further supporting liability classification? If classified as a liability, is the entire instrument at fair value through profit or loss, or does an embedded conversion derivative need separation from a host debt contract?

1) Obtain the full instrument terms (valuation cap, discount rate, most-favored-nation clauses, maturity/redemption features) before concluding on classification. 2) Apply the fixed-for-fixed test: does the instrument convert into a fixed number of shares for a fixed amount of cash, determined at inception? If the number of shares varies with a future round's price, cap, or discount, the test fails. 3) Check for any redemption right that could require cash settlement (e.g., on a maturity date if no qualifying round occurs), which further supports liability classification. 4) Where the instrument fails fixed-for-fixed, classify it as a financial liability (not equity) and recognize it initially at the fair value of proceeds received. 5) Determine whether the whole instrument should be at fair value through profit or loss, or whether an embedded conversion derivative must be separated from a host debt contract (relevant if the instrument is not designated at FVTPL in its entirety). 6) Reassess classification if the instrument's terms are amended (e.g., extended maturity, repriced cap).

Measure the liability-classified instrument (or its embedded conversion feature) at fair value through profit or loss, with changes in fair value driven by factors such as time to expected conversion, probability-weighted funding round scenarios, valuation cap proximity, and discount rate assumptions; use a probability-weighted scenario approach (e.g., an option-pricing or scenario/Monte Carlo model) suited to an illiquid, unlisted instrument, and document the key assumptions and their sensitivity.

Disclose: the instrument presented as a financial liability (current or non-current based on expected conversion/settlement timing) rather than within equity; the valuation methodology, key inputs and assumptions used to estimate fair value; the resulting fair value gains or losses recognized in profit or loss for the period; and a sensitivity analysis showing the effect of reasonably possible changes in key assumptions (e.g., valuation cap, timing) on the liability's fair value.

• Classifying SAFEs or convertible notes as equity by default because they are marketed as '
• future equity'
• instruments, without testing the fixed-for-fixed criterion
• failing to remeasure the liability to fair value at each reporting date, instead carrying it at issuance amount
• not separating an embedded derivative from a host contract when the instrument is not wholly at fair value through profit or loss
• ignoring the effect of a most-favored-nation clause (which can reset terms if a later, more favorable instrument is issued) on the fair value model
• treating all SAFEs identically without checking whether each specific instrument'
• s terms actually pass or fail the fixed-for-fixed test.