Startup Q&A
How should convertible note financing be handled on the balance sheet?
CEO and Founder of Kruze Consulting
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A convertible note should be classified as a Long Term Liability that then converts to Equity as stipulated from the contract (usually a new fundraising round).
Mechanically, a convertible note represents an exchange of an investor’s money for a convertible debt instrument that will allow the investor to make a modest amount of interest until the note matures or “converts”. At the time of maturity, the investor will either get their money back, roll it over and extend, or convert it to equity. Generally, in Silicon Valley, the investor converts the note into equity at the next financing round. So, from an accounting perspective, you have a long-term liability that (in most circumstances, or at least in most good outcomes) converts into equity.
Assuming that there’s a $3,027,000 note with $181,620 in total accrued interest, you’ll have the outstanding note as a liability, plus then you can add another line with the accrued interest. You could consolidate these for presentation purposes, but it’s often easiest to look at them broken out.
This link shows a balance sheet liabilities equity Series A, so you can see what it might look like as converted.
Remember, the balance sheet is trying to balance the assets against the liabilities + equity. So the cash coming in from your convertible note will generally equate to the liability that you add to the balance sheet. And, if your accounting is doing a good job, the accrued interest is a non-cash expense that flows through your income statement and impacts your accumulated net income in the equity section.
How to account for seed or venture capital raises on your balance sheet?
Note that SAFE notes are Equity right from the start
And we have an entire page that talks about convertible notes and some of their accounting (and strategic) implications.
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