The venture capital landscape has always been dynamic, but recent economic turbulence — driven by persistent inflation, ongoing uncertainty around Federal Reserve policy, and rising geopolitical tensions — has added new layers of complexity, particularly in the life sciences sector. Volatility in the capital markets has heightened investor caution and made traditional equity financing more difficult to secure.

Life sciences companies, which depend heavily on continuous funding for research and development (R&D) and clinical trials, are significantly impacted. In response, there has been a notable increase in the use of alternative financial instruments, including convertible notes, Simple Agreement for Future Equity (SAFE) notes, and tranche financing. These alternative financial instruments allow founders to bridge funding gaps while preserving flexibility and avoiding immediate repayment obligations or significant ownership dilution. For investors, these instruments offer downside protection along with the potential for upside in the event of successful exits.

Based on Stout’s recent client experiences, we have observed a growing trend of companies leveraging these alternative financial instruments to secure necessary capital. This shift underscores the importance of comprehending the accounting and valuation implications for companies and their investors.

Types of Alternative Financial Instruments

Convertible notes are hybrid securities that combine debt-like and equity-like features. Convertible noteholders can receive payments of accrued interest and principal or have the option to convert the indebtedness into a company’s equity. This structure provides investors with downside protection as debtholders while allowing upside participation upon conversion.

In the life sciences sector, we typically see convertible notes with options to convert into equity upon specified events such as future equity financing, a Change of Control (CoC) or liquidity event, or an IPO. Key terms often include a discounted conversion price, which provides investors with a sweetener via a gross-up payoff, and a valuation cap, which sets the maximum price at which the notes can be economically convertible. Additionally, provisions for default or dissolution events address scenarios where the company cannot successfully repay the indebtedness on time.

SAFE notes are similar to convertible notes but typically do not accrue interest or have a maturity date. They offer investors the chance to convert the notes into equity upon a triggering event, usually the next equity financing round. They often include a valuation cap and/or a discounted conversion price to compensate early investors for their risk.

Tranche financing involves releasing funds in stages (tranches) based on the company achieving predefined milestones. This approach mitigates risk for investors by tying capital investment or deployment to the company’s performance. Typically, the financing agreement specifies that investors are obligated to purchase additional shares upon the completion of specific milestones by the company, often related to clinical trial or study progress. However, when tranche financing investors control the board, the obligation to purchase additional shares essentially becomes their option, providing them with greater flexibility in managing their investment.

Accounting Considerations

Accounting for convertible notes, SAFEs, and tranche liabilities, including any associated embedded derivatives, is often complex, and each instrument possesses its own distinctive attributes. As a result, companies must take a nuanced approach for each and carefully consider the applicable accounting guidance and steps, including ASC 480, ASC 815, ASC 820, and ASC 825, to ensure accurate and compliant financial reporting.

Convertible notes present a multifaceted accounting challenge, as entities must determine whether the embedded conversion and/or redemption features qualify as derivatives and if bifurcation is necessary. ASC 815, Derivatives and Hedging, typically governs this assessment, guiding entities in discerning the appropriate treatment for these features to accurately reflect fair value and any resulting gains or losses for each reporting period.

Furthermore, if eligible, companies may elect the fair value option (FVO) under ASC 825, allowing the valuation of convertible notes in totality. ASC 825, Financial Instruments, provides the framework for electing the FVO, enabling entities to measure eligible financial assets and liabilities at fair value in totality, with changes in fair value recognized in earnings. This option simplifies the accounting process by bypassing the bifurcation of embedded derivatives and providing a straightforward approach to recognizing gains or losses in value. If an instrument does not have any identifiable embedded features, ASC 470, Debt, may apply.

SAFE notes typically require analysis to determine whether they meet the criteria for liability classification under ASC 480, Distinguishing Liabilities from Equity. Additionally, similar to convertible notes, the presence of conversion and/or redemption features in SAFE notes may necessitate assessment of ASC 815 or ASC 825, depending on whether the company has elected the FVO.

Tranche financing arrangements introduce additional complexities, particularly concerning the tranche liability. As an embedded derivative within a preferred financing, ASC 815 is typically the applicable guidance. However, in certain circumstances, ASC 480 may apply if the embedded features do not require bifurcation or separate accounting.

Any aspect of these instruments subject to fair value measurement must adhere to the principles outlined in ASC 820, Fair Value Measurement. This standard provides a structured framework for determining fair value, emphasizing the importance of utilizing observable market inputs when available and establishing a hierarchy for valuation techniques.

Valuation Approaches and Methodologies

Convertible Notes / SAFE Notes

When technical accounting experts or auditors determine that convertible notes / SAFE notes or their embedded derivatives require separate recognition, their fair value should be assessed for each required reporting period.

A convertible note is typically valued at inception based on its face value, with the yield implied by discounting expected future payoffs to equal either the face value or the actual proceeds received, assuming no issuance discount or attached warrants. This approach presumes an arm’s-length transaction, where the fair value of the instrument is established through negotiations between unrelated parties. Once the implied yield is determined, subsequent valuations of the note at future reporting dates use the calibrated yield, adjusted for the market changes. These adjustments may reflect shifts in the market yield curve, changes in the issuer’s credit risk, or revised assumptions related to various exit or conversion scenarios. They may also account for any changes in the note’s face value.

Valuing convertible notes or SAFEs typically involves a scenario-based approach that incorporates the instruments’ embedded optionality in addition to the straight debt component. In the biotech and life sciences sectors, these instruments often include multiple potential payoff events and complex repayment or conversion provisions. Common payoff scenarios include new equity financing, CoC and liquidity events, going public (e.g., IPO, reverse merger, or Special Purpose Acquisition Company [SPAC]), and potential company dissolution. Key provisions or features influencing valuation may include conversion price discount, valuation cap, mandatory conversion upon a qualified financing, and optional conversion or repayment upon a CoC or IPO.

While lattice binomial models and Monte Carlo simulations are widely favored for their flexibility and ability to capture a broad range of variables and outcomes, methods such as “Bond Plus Call” and “As-Converted Plus Risky Put” are also commonly used, particularly in our recent work with biotech and life sciences companies. These approaches are especially effective when addressing features like valuation caps or sub-class preferred structures (e.g., conversion into SAFE preferred stock rather than standard preferred stock). Their scenario-driven design offers a streamlined framework that is often easier for reviewers to understand and audit.

The Bond Plus Call method treats a security with a valuation cap or fixed conversion price as a combination of a straight bond and a call option on the issuer’s equity. The bond component is valued based on its fixed-income characteristics, while the call option captures the potential upside from converting into equity. This approach is typically applied when the current equity value is below the valuation cap, that is, when the option is “out-of-the-money.” In this method, the cap price acts as the hypothetical conversion threshold and serves as the strike price in the Black-Scholes option pricing model.

Notes Fair Value = Present Value of Total Indebtedness + Conversion Option Value using Black-Scholes

The As-Converted Plus Risky-Put Method, similarly, values the notes by considering its conversion feature alongside a put option that protects the investor’s downside risk. This method is typically used when the current equity value has been noticeably higher than the valuation cap, representing an “in-the-money” condition.

Notes Fair Value = Current Share Value if Conversion + Protective Put Option Value using Black-Scholes

In tranche financing, when valuing the tranche liability, it is important to first assess the nature of the investor’s rights under the accounting framework — specifically, whether the future tranche obligation is treated, accounting wise, as a forward contract or an option. This classification determines the appropriate valuation methodology.

• Simplified Binomial Model: If the tranche is considered a forward contract, often the case when the company is obligated to issue additional shares in the future, then a simplified binomial model (typically with two to three nodes) can be employed to capture the probability-weighted value of the future issuance.
• Black-Scholes Model: In contrast, if the tranche is treated as an option, generally occurring when investors have effective control over the board of directors and thus discretion over whether or not to fund future tranches, a Black-Scholes model is more appropriate to reflect that optionality.

Regardless of the framework used, tranche financing often results in a situation where the implied current price per share is lower than the stated price in the financing documents. This is because the tranche structure embeds future rights or obligations into today’s price, effectively transferring part of the future tranche’s value into the initial investment. In practice, this requires careful calibration of the model to the overall terms of the financing, including any governance provisions, funding milestones, and investor rights, to ensure that the contingent value is appropriately captured in the liability measurement.

Proactive Planning

Accurately accounting for and valuing convertible notes, SAFEs, and tranche liabilities requires expertise and experience with complex accounting guidance and valuation models. Engaging technical accounting and complex security valuation teams early can streamline a company’s close, audit, and filing processes.

Auditors also play a critical role in these decision-making processes, particularly during SEC filings. When auditors pinpoint instances where complex financial instruments require third-party valuations, a valuation team can assist companies in ensuring compliance with regulatory standards and accurate financial reporting.