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How to Account for Series Funding Rounds Under UK GAAP

How to Account for Series Funding Rounds Under UK GAAP

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  • Accounting of financing rounds is determined by the nature of the instruments issued, not by the funding stage
  • This article summarises accounting treatment under UK GAAP (FRS 102) for some of the commonly issued instruments during funding rounds in the UK

Background

If you are researching on how to account for financing rounds, it means you have already secured or are in the process of securing funding for your company/startup. This is a huge milestone for any business – so congratulations!

Financial reporting in the UK is broadly derived from a combination of two sources – the first is the financial accounting and reporting frameworks such as FRS 101, FRS 102 and FRS 105, etc. that are maintained by the Financial Reporting Council (FRC). The second is incremental requirements prescribed in legislation such as The Companies Act 2006 and various other Statutory Instruments. Together, these two sources form United Kingdom Generally Accepted Accounting Principles, or UK GAAP.

Accounting for a Funding Transaction

Funding rounds can take many shapes and forms. These can be early financing a company secures, for example seed or series rounds, or issuance of fresh instruments for more established companies. The accounting for these funding rounds is not determined by the stage of the round. Rather, it is determined by the nature of the instruments issued within each round. The following are some examples of commonly issued instruments by companies to secure funding and how these may be accounted for under UK GAAP (FRS 102):

Common Shares

This is the most common type of instrument issued by companies during a funding round. Companies will often issue various classes of common shares to distinguish between some of the rights associated with them (for example Series A shares or Series B shares). All such shares are treated as equity.

Preference Shares

Another common instrument issued by companies to raise financing is preference shares. Certain types of preference shares are classified as liabilities rather than equity. FRS 102 requires classification of preference shares to be based on assessment of underlying contractual provisions, with due consideration given to definitions of liability and equity under the standard.

Warrants

Warrants give the holder an option to subscribe to more equity in a company at a later date. Such instruments require careful consideration of their contractual terms to determine whether these are equity instruments or financial liabilities and derivatives. The accounting for both types of instruments differs significantly.

Convertible Loan Notes

Another very common instrument issued by companies during a funding round is convertible loan notes, or CLNs. Under the typical terms of a CLN, the holder lends cash or other assets to the company with the option to convert the loan to equity instruments at a later date. CLNs can be very complex to account for. FRS 102 has several considerations across different sections of the standard that are required to be applied to account for CLNs. Some CLNs may be treated under IFRS 9 as opposed to FRS 102. Companies may find this accounting policy choice more convenient to apply given that IFRS 9 prescribes the accounting treatment for embedded derivatives whereas FRS 102 does not.

In addition, CLNs are often compound financial instruments, which means that they contain an element of both equity and liability. Both these elements are required to be separately identified and accounted for under FRS 102 and IFRS 9.

Royalty shares

Arrangements for royalty shares can take many forms. The most common arrangements include exchanging shares for a license or in lieu of payment of royalties. Royalty shares require a careful consideration of the underlying terms of the arrangement to determine whether these are in scope of sections prescribing accounting treatment for intangible assets, equity or share-based payments.

SAFE notes

Simple Agreement for Future Equity, or SAFE, notes are seeing increasing popularity in VC-back funding rounds. These are fast and simple to execute, offering quicker access to cash and other assets for companies in exchange for a promise to investors to subscribe them to equity at a later date. Typically, SAFE notes do not qualify for recognition as liabilities and are usually treated as equity instruments. However, an assessment of the underlying terms of SAFE notes is required to ascertain whether these meet the criteria to be classified as debt or equity under FRS 102.

Share-based payments

Share-based payments arrangements during a financing round can relate to employee incentive programs (i.e. achieving the milestone round) or payments made to suppliers, such as advisors, using a company’s equity instruments as opposed to cash or other assets. The rules governing both types of share-based payments differ, but share-based payments related to suppliers are often easier to account for than those related to employee incentive programs.

How FD Can Help

Frazier & Deeter has helped numerous finance teams account for their funding rounds. If you would like to discuss the accounting treatment of your upcoming funding round, or would like to engage us to help account for one you have already concluded, please contact us here.

Contributors

Ali Amar, Senior Manager

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