Off balance sheet items are usually spoken of in hushed tones when public companies crash and burn, usually in the haze of opaque financial disclosures. But startup founders - and the VCs that work with them - should also be aware of off balance sheet items, as they can represent real corporate obligations.
What Are Off Balance Sheet Items?
Off-balance sheet items refer to assets or liabilities that are not recorded on a company’s balance sheet. These items can have a significant impact on a company’s financial health, although they are not explicitly presented in the main financial statements. Understanding these items is crucial, especially for startups and VC-backed companies as they can affect funding decisions and overall financial strategy. Here are some common off-balance sheet items:
Common Off Balance Sheet Item Examples
- Operating leases - operating leases USED to be one of the prime examples of off balance sheet items. However, accounting rules changed (some might say caught up with reality) and they are now captured, in most cases, on the financial statements as a liability. These are leases where the asset doesn’t meet the definition of being owned by the company, but are leased for a specific period of time.
- Contingent Liabilities
- Examples: Lawsuits, warranty obligations, or environmental cleanup obligations.
- Impact: These liabilities are potential and will only become actual liabilities if certain events occur. They can significantly impact future finances. There are specific tests that must be met in order to have these hit the balance sheet. However, for VCs doing due diligence - and for founders raising funding - these should be disclosed even if they don’t meet the accounting definition to be officially recorded on the financial statements.
- Letters of Credit and Guarantees
- Usage: Often used in international trade or as guarantees for loans.
- Impact: They represent potential obligations that could convert into actual liabilities under specific circumstances. An example of a startup that would have this type of contingent liability might be a biotech company that is purchasing a very expensive piece of equipment.
- Derivative Instruments
- Types: Includes futures, options, swaps.
- Impact: They can have significant financial implications but are often not recorded as assets or liabilities until they are exercised or settled. The accounting for derivatives is very complicated - it’s important that founders work with experienced CPAs to get these booked correctly. And we always recommend disclosure when raising capital; make sure your VCs know if you have these kinds of instruments (and why).
- Joint Ventures and Special Purpose Entities (SPEs)
- Structure: Collaborative arrangements with other entities.
- Impact: The financial risks and benefits from joint ventures are not fully reflected on the balance sheet but can affect financial performance. These are another complicated type of transaction that will require disclosure if you are talking to VC investors.
So, while it’s not common for startups to have off balance sheet items, it can happen. Always disclose these types of agreements and transactions to the board and investors!
VC Investments and Balance Sheet Recording
When a startup receives VC funding, the way this investment is recorded on the balance sheet varies based on the nature of the investment.
Equity Investments
Recording: Equity investments are recorded as a part of the shareholders’ equity section.
Impact: It increases the total equity of the company, reflecting the ownership stake acquired by the VC.
Convertible Instruments
SAFE Note Accounting: A SAFE (Simple Agreement for Future Equity) note is a popular convertible instrument. For “SAFE note accounting,” these are often recorded as a liability until the point of conversion.
How to Record Convertible Notes: Convertible notes are initially recorded as a liability. The “how to record convertible notes” process involves recognizing these notes as debt until they convert into equity, typically after a future financing round.
The Cap Table: A More Comprehensive Story
The cap table provides detailed information about who owns what in a company. It is crucial for understanding the full impact of VC investments. It serves as a detailed ledger that outlines the percentage ownership, equity dilution, and the equity value allocated to each investor and stakeholder. While investments are recorded on the balance sheet, it’s important to also have a cap table software that keeps careful track of each individual investor, option holder and security. This is crucial in giving a clear picture of who owns what in the company. Additionally, the cap table is instrumental in tracking the conversion of instruments like SAFE notes and convertible notes into equity, a process that can significantly alter the ownership structure of the company. Moreover, it aids in the planning and negotiation of future funding rounds by providing a clear view of how these rounds will impact ownership and dilution among existing stakeholders. The cap table, therefore, is not just a record-keeping tool but a strategic asset for managing investor relations and guiding financial decision-making.
Conclusion
For startups and VC-backed companies, it’s essential to not only focus on the balance sheet but also to understand and manage off-balance sheet items. These items can play a significant role in financial planning, investment negotiations, and overall corporate strategy. And they may represent large liabilities that need to be disclosed to investors.
