Classification of funding instruments: debt, equity or hybrid

Startup funding instruments (SAFEs, convertible notes, preference shares) routinely contain redemption rights, variable-price conversion, or liquidation preferences that push them toward liability classification or embedded derivative accounting under IAS 32/IFRS 9, even when the term sheet is labeled 'equity.' Getting this wrong overstates equity and understates leverage precisely when investors and lenders are assessing solvency, and a liability classification typically forces fair value remeasurement through profit or loss each period, injecting volatility that a simple equity classification would not show.

Does the instrument give the holder an unavoidable contractual right to demand cash back, or a fixed maturity date requiring cash settlement? Does conversion occur at a fixed number of shares for a fixed amount of cash, or does a discount, cap, or variable-price mechanism cause the fixed-for-fixed test to fail? Are there mandatory or cumulative dividend features, or liquidation preference terms, that would push classification toward a liability rather than equity?

1. Read the instrument clause-by-clause rather than relying on its label (SAFE, convertible note, preferred share), classification follows substance, not the term used in the term sheet.
2. Test whether the entity has an unavoidable contractual obligation to deliver cash or another financial asset (e.g., a redemption right the holder can exercise, a maturity date with cash settlement); if so, classify as a liability.
3. If settlement is in the entity's own equity instruments, apply the fixed-for-fixed test: the instrument is only equity if it will be settled by delivering a fixed number of the entity's own shares for a fixed amount of consideration.
4. Where the conversion price varies (e.g., a discount to the next funding round, or a valuation cap creating a variable number of shares for a fixed investment amount), the fixed-for-fixed test fails and the instrument (or its conversion feature) is a financial liability, generally at fair value through profit or loss.
5. For compound instruments with separable host and conversion components (e.g., a convertible bond with a fixed conversion ratio), assess whether a bifurcated equity conversion option can be separated from a liability host; for SAFEs and most variable-conversion notes, the whole instrument is usually liability-classified rather than split.
6. Re-perform this classification analysis whenever terms are amended or a new funding round changes the mechanics of conversion.

Measure liability-classified instruments initially at fair value (typically the cash received, adjusted for any embedded features priced separately), and subsequently either at amortized cost using the effective interest method (for straightforward debt-like instruments with no substantive variable conversion feature) or at fair value through profit or loss where a conversion or redemption feature is variable and cannot be reliably separated. Fair value remeasurement of SAFEs and variable-conversion notes typically uses an option-pricing or probability-weighted scenario model reflecting the next funding round's expected price, discount, and cap, updated at each reporting date. For genuinely equity-classified instruments, measure at the consideration received, net of issuance costs, with no subsequent remeasurement.

Disclose: contractual terms of each material funding instrument (conversion mechanics, redemption rights, liquidation preferences); the classification judgment reached and the key clauses driving it; whether the fixed-for-fixed test was met; fair value of liability-classified instruments and the valuation technique and key inputs used; fair value gains/losses recognized in profit or loss and where they are presented; any reclassification triggered by amended terms or a new funding round.

• Booking SAFEs and convertible notes as equity by default because they are commercially perceived as '
• quasi-equity'
• financing
• overlooking that a discount-to-next-round or valuation-cap conversion mechanism creates a variable number of shares, which fails the fixed-for-fixed test
• treating a redeemable preference share as equity simply because it is called a '
• share'
• ignoring the need to remeasure liability-classified instruments to fair value each period, leaving stale initial-recognition amounts on the balance sheet
• failing to reassess classification after a term amendment or new funding round changes the conversion mechanics
• not engaging valuation specialists for instruments with genuinely complex option-like features.