Series A Journal Entry: Preferred Stock, SAFEs and Fees

How do you record a Series A in the books?

Record the round on the closing date as one entry per source of money: cash wired at closing, SAFEs that converted and notes that converted. Each entry credits the preferred stock account for shares issued times par value and credits additional paid-in capital for the rest. Closing fees then reduce paid-in capital. Nothing goes to revenue: a corporation recognizes no gain when it issues its own stock for money (26 U.S.C. 1032).

What makes a round not simple:

• SAFEs carried as a liability at fair value, or notes with a conversion feature split out as a derivative. The auditor decides the classification, and the carrying amount must be current before it moves to equity.
• Money that arrived before closing, a second tranche, or investors who funded only part of their commitment.
• Preferred shares issued at more than one price (new money and conversion shares).
• Founder or early shares on the cap table that the books never recorded.

What to gather: the stock purchase agreement, the closing statement and funds flow, the pro forma cap table, the amended certificate of incorporation (authorized shares and par value), every SAFE and note with its conversion math, the bank statement showing the wires, and the legal invoices. The IRS asks businesses to keep the documents that support the entries in their books (Publication 583).

What is the journal entry for preferred stock issued for cash?

Debit cash for the amount wired. Credit preferred stock for the number of shares issued times the par value in the certificate of incorporation, and credit additional paid-in capital for the difference between the purchase price and par.

If the investors' counsel fees were withheld from the wire, cash is the net amount received. Record the full purchase price in preferred stock and paid-in capital, then debit paid-in capital for the withheld fees so the entry balances.

Use one preferred stock account per series (Seed, Series A). Each series has its own rights, so the books and the cap table should show them apart. Schedule L of Form 1120 combines them on one preferred stock line.

Why does par value matter, and what goes to additional paid-in capital?

Par value sets the minimum price and the legal capital of the shares. In Delaware, shares with par value must be issued for consideration worth at least par (8 Del. C. 153). Unless the board resolves otherwise at issue, the capital for shares issued for cash equals their total par value; surplus is net assets above capital (8 Del. C. 154).

In the books, the price above par is additional paid-in capital. With a typical startup par value, almost the whole price goes there, and the preferred stock account holds a few hundred dollars.

Par value and authorized shares also drive the Delaware franchise tax calculation; see Delaware franchise tax. Corporations formed in other states follow their own state's corporate law on par value and capital; read the certificate of incorporation before posting.

SAFE conversion journal entry: how do SAFEs come off the balance sheet?

At closing, each SAFE becomes preferred shares, so the SAFE account goes to zero. Debit the SAFE account for its carrying amount and credit preferred stock at par and additional paid-in capital for the rest. Nothing about the SAFE should remain on the balance sheet after the entry.

The carrying amount depends on how the books classified the SAFE:

• Carried at the amount paid in equity: move that amount to preferred stock and paid-in capital.
• Carried as a liability at fair value: update the fair value to the conversion date first, with the change in the book income statement, then move the updated amount to equity.

Which classification applies is an accounting judgment the auditor makes. How SAFEs should have shown before the round is covered in cleaning up your books before fundraising, and the tax side of the conversion in SAFEs and convertible notes.

Convertible note conversion: what happens to the note and accrued interest?

When a note converts, debit the note payable and the accrued interest that converts with it, and credit preferred stock at par and additional paid-in capital. The number of shares comes from the note's terms, usually principal plus accrued interest divided by the conversion price.

Bring interest up to the conversion date before posting, so the accrued interest account matches the amount the note holders' shares were calculated on. If the note carries unamortized issuance costs or a discount, its net carrying amount is what moves to equity.

If the books split the note's discount or cap feature into a separate derivative, or the note converted on terms other than its original ones, the entry can differ; the auditor sets it. Whether the conversion creates income for tax, and when the interest is deductible, is covered in SAFEs and convertible notes.

Where do the round's legal and closing fees go?

In the books, costs that exist only because of the round reduce the proceeds in equity: debit additional paid-in capital, not legal expense. In guidance written for companies that file with the SEC, the SEC staff allows specific incremental costs of an offering to be deferred and charged against the gross proceeds (SEC Staff Accounting Bulletin Topic 5A).

• Fees paid before closing sit in a deferred offering costs asset until the round closes.
• General overhead and management salaries are not offering costs.
• If the round is abandoned, the deferred costs are expensed; a postponement of up to 90 days does not count as abandoned under the same guidance.

For tax, amounts paid to facilitate a stock issuance must be capitalized, not deducted (26 CFR 1.263(a)-5(a)(8)). When the books never expensed the fees, there is nothing to add back on Schedule M-1. Fees for a note or other borrowing follow different rules; see SAFEs and convertible notes.

Money arrived before closing, or the round closes in tranches: how is it recorded?

Money received before the shares are issued is not yet equity. Until closing, the company owes the investor either shares or a refund, so record the wire in a liability account (for example, stock subscriptions received in advance) and move it to preferred stock and paid-in capital on the closing date. Delaware stock is issued at the times and for the consideration set by board resolution (8 Del. C. 152).

For a round that closes in tranches, record each closing when its shares are issued and paid for. A commitment to buy more shares later is not an entry on its own. If later tranches are priced in advance or depend on milestones, the right to buy those shares may need its own accounting; ask the auditor before the first close.

How do we tie equity in the books to the cap table after closing?

The books tie to the cap table when each stock account equals issued shares times par, and stock plus paid-in capital equals what the company received for every share, less issue costs, plus amounts credited for stock compensation and for any warrants recorded in equity.

The common traps are a wire posted as revenue or as a loan, and a cap table showing shares (often founder shares) the books never recorded. If stock compensation was never booked, see catching up on stock compensation expense.

Does the round create income, and how does it show on Form 1120 Schedule L?

Not from the cash. Cash received for the corporation's own stock is not gain (26 U.S.C. 1032), and records should separate taxable from nontaxable receipts so the wire is not counted as gross receipts (Publication 583). A note converted into stock worth less than the debt can create cancellation of debt income (26 U.S.C. 108(e)(8)); see SAFEs and convertible notes.

On Schedule L of Form 1120, besides cash on line 1 (and any deferred offering costs it clears), the round shows only in equity and the liability lines it clears:

Schedule M-2 analyzes retained earnings, so the conversion entries do not pass through it. A fair-value change on a liability SAFE does, through book income, and goes on Schedule M-1 when the return does not include it. Schedule L should agree with the books (Instructions for Form 1120). A corporation with total receipts and year-end assets both under $250,000 can skip Schedules L, M-1 and M-2 by answering Yes to Schedule K, question 13; one with year-end total assets of $10,000,000 or more files Schedule M-3 instead of M-1 (Instructions for Form 1120). A large round can cross either line in the year it closes.

Example

Series A for cash

All figures in US dollars. A Delaware corporation sells 2,000,000 Series A preferred shares at $4.00, par $0.0001. The closing entry debits cash $8,000,000, credits Series A preferred stock $200 and credits additional paid-in capital $7,999,800. Schedule L shows $200 on line 22a and $7,999,800 added to line 23.

SAFEs and a note convert

All figures in US dollars. At the same closing, $1,500,000 of SAFEs carried at the amount paid and a $500,000 note with $40,000 of accrued interest convert at $3.00 a share. The SAFEs become 500,000 shares and the note 180,000 shares. The entry debits the SAFE account $1,500,000, notes payable $500,000 and accrued interest $40,000; it credits preferred stock $68 and additional paid-in capital $2,039,932. No SAFE, note or interest balance is left.

$120,000 of legal fees

All figures in US dollars. The company's counsel bills $120,000 for the round, $30,000 of it paid before closing and held as deferred offering costs. At closing, additional paid-in capital is debited $120,000, deferred offering costs are cleared and the remaining $90,000 is paid. Equity shows the proceeds net of the fees. The Form 1120 does not deduct the fees, and because the books never expensed them, Schedule M-1 has no adjustment for them.

Different for you?

• The tax on SAFE and note conversion, note interest, or whether round fees are deductible: SAFEs and convertible notes.
• SAFEs, notes or founder shares were never recorded properly before the round: cleaning up your books before fundraising.
• The round authorized many more shares: Delaware franchise tax.
• The new investors bought a large stake and the company has losses: net operating losses for startups.
• Investors want the stock confirmed as QSBS after the money arrives: small business stock exclusion for startups.
• The raised cash now earns interest: interest on a startup's raised cash.
• Option grants follow the round: granting stock options after a valuation.
• The lead investor asks for an audit: audited financials for investors.
• Foreign investors or note holders are in the round: foreign investors in a startup round.
• Notes matured before any priced round: convertible notes past maturity.
• The round came with venture debt and warrants: venture debt and warrants.
• A US corporation with a priced round, conversions and an auditor's questions to settle: startup services.