How to Account for Convertible Grants Turning into Equity for Biotech and Deeptech

Understanding How to Account for Grants Turning into Equity

For a biotech or deeptech startup, securing a major grant feels like a huge win. It’s often non-dilutive capital that extends your runway, allowing you to focus on critical R&D milestones. But when the grant agreement includes a clause for future equity conversion, the accounting gets complicated fast. It isn’t simple income, and misclassifying it can create significant problems for your balance sheet, cap table, and future fundraising efforts.

Understanding how to account for grants turning into equity is not just a compliance exercise; it’s a strategic necessity for maintaining a clean financial picture and building investor trust. Mismanagement can lead to difficult conversations during due diligence, potentially delaying or even jeopardizing a funding round. This guide provides a practical, step-by-step process for managing the entire lifecycle of a convertible grant, from initial receipt to final equity conversion. See our Government Grants & Contract Accounting hub for more project-based accounting guidance.

Foundational Concepts: Is It Debt, Equity, or Income?

The central challenge with these grants is that they don’t fit into a standard accounting box. So, what are they? Convertible grants are hybrid financial instruments with characteristics of both liability and equity. At first glance, the cash infusion might look like income. However, the obligation to issue shares in the future means you haven’t truly “earned” it in the traditional sense. Recognizing it as revenue would incorrectly inflate your startup’s profitability and misrepresent its financial health to investors and stakeholders.

Conversely, it’s not pure equity yet because no shares have been issued. The conversion is contingent on a future event, typically a priced funding round. Therefore, the most appropriate initial treatment is to recognize the grant as a liability on your balance sheet. This entry reflects the reality that the company owes something back to the granting body, an obligation that will be settled by issuing stock later. The grant to equity conversion process begins by acknowledging this hybrid nature and recording the initial obligation correctly.

Step 1: Recording the Grant on Day One in the Pre-Conversion Stage

When the grant money arrives, your first task is to record it correctly in your accounting system, whether that's QuickBooks or Xero. Missteps here can lead to painful corrections down the line, often discovered during a time-sensitive audit or fundraising due diligence. The key is to avoid crediting a revenue account, as this will overstate your income and require a formal restatement later.

The most common and conservative approach is the liability method. This is the clearest way to handle the accounting for convertible grants because it directly reflects the obligation to issue future equity. It presents a transparent view of the company's commitments.

Here’s the initial journal entry:

• Debit: Cash. This increases your cash balance in the bank.
• Credit: Convertible Grant Liability. This creates a new liability on your balance sheet.

In practical terms, you would navigate to your Chart of Accounts in your bookkeeping software and create a new liability account. Whether you classify it under 'Other Current Liabilities' or 'Long-Term Liabilities' depends on the expected conversion timeline. If a funding round is anticipated within 12 months, it is typically a current liability. If the timeline is longer, it can be classified as long-term. Naming it something specific like “Innovate UK Convertible Grant” helps with tracking and transparency.

Under specific accounting standards, particularly International Financial Reporting Standards (IFRS), another option exists. The standard IAS 20, which governs 'Accounting for Government Grants', allows presentation as either deferred income or a deduction from a related asset. While the deferred income method is an option, the conversion feature often makes the financial liability approach cleaner for startup grant compliance, especially when the primary purpose is funding operations rather than acquiring a specific asset. For most pre-seed startups, the liability method is simpler to implement and much easier to explain to investors.

Step 2: Managing the Conversion Event and Recognizing Grant-Related Equity

The conversion event is the trigger that transforms the grant from a liability into equity. This is typically a qualified financing round, such as your Series A, where new investors purchase shares at an agreed-upon price. At this point, you must execute the financial reporting for grant conversions by moving the value from the liability side of your balance sheet to the equity side. This is a critical step in cleaning up your financials ahead of the new investment.

Let’s walk through a detailed example of the equity treatment of government funding in action.

A Practical Example of Conversion

Consider a deeptech startup that received a $100,000 convertible grant. The agreement specifies the grant converts into equity at the next financing round with a 20% discount to the new share price. The startup now closes a $5 million Series A round at a price of $1.00 per share.

1. Calculate the Conversion Price. The Series A investors are paying $1.00 per share. Because the grant holder gets a 20% discount, their conversion price is lower. The calculation shows that if a Series A price per share is $1.00, a 20% discount results in a conversion price of $0.80 per share. ($1.00 x (1 - 0.20) = $0.80).
2. Determine the Number of Shares. Next, you calculate how many shares the grant provider receives for their initial funding. A $100,000 grant converting at $0.80 per share results in 125,000 shares being issued to the grant-making body. ($100,000 / $0.80 = 125,000 shares).
3. Record the Journal Entry. This final accounting entry removes the liability from your books and creates the new equity. It is a pivotal moment in the grant's lifecycle.
   • Debit: Convertible Grant Liability ($100,000). This clears the liability account you created in Step 1, bringing its balance to zero.
   • Credit: Share Capital / Common Stock ($12.50). This entry reflects the par value of the newly issued shares. For example, 125,000 shares at a nominal par value of $0.0001 equals $12.50.
   • Credit: Additional Paid-In Capital (APIC) / Share Premium ($99,987.50). This account receives the remaining amount, representing the value paid for the shares above their par value.

This journal entry correctly shows that the $100,000 obligation has been settled not with cash, but by issuing ownership in the company. The liability is gone, and the company’s equity has increased by $100,000, reflecting the grant provider’s new status as a shareholder.

Step 3: After Conversion — Managing Your Cap Table and Dilution

Recognizing grant-related equity on the balance sheet is only half the battle. The conversion’s most significant impact for founders is on the company’s ownership structure, or capitalization table. The issuance of 125,000 new shares to the grant provider dilutes the ownership percentage of all existing shareholders, including founders and early investors.

Quantifying this dilution is essential to avoid surprises. Let’s extend our example. Before the Series A and grant conversion, the company’s cap table was simple:

Pre-Conversion & Pre-Series A Cap Table

• Founders: 8,000,000 shares (80%)
• Pre-Seed Investors: 2,000,000 shares (20%)
• Total Shares: 10,000,000

Now, the grant converts (adding 125,000 shares) and the Series A investors purchase 5,000,000 new shares. The post-conversion cap table looks very different:

Post-Conversion & Series A Cap Table

• Founders: 8,000,000 shares (52.9%)
• Pre-Seed Investors: 2,000,000 shares (13.2%)
• Grant Provider: 125,000 shares (0.8%)
• Series A Investors: 5,000,000 shares (33.1%)
• Total Shares: 15,125,000

The founders’ ownership has dropped from 80% to 52.9%. This is a normal part of fundraising, but managing convertible grant agreements requires you to model this impact ahead of time. As a company grows, spreadsheets become risky for this task. Using dedicated cap table management software like Carta or Pulley becomes necessary to accurately model dilution from multiple sources and maintain a clean, auditable record of ownership. You can find more policy guidance in our Grant Accounting Policy Template for Startups.

Special Consideration: Navigating UK vs. US Accounting Rules

For startups with operations or investors on both sides of the Atlantic, aligning UK and US accounting rules is a common challenge. While the day-to-day bookkeeping of recording a liability and converting it to equity is similar, the underlying authoritative guidance differs.

United Kingdom (IFRS)

In the UK, the process is guided by IFRS and local standards like FRS 102. As noted, IAS 20 provides the framework for government grants. Programs like those from Innovate UK, a common source of convertible grants, fall under this jurisdiction. The key is to carefully document the grant's terms and justify the accounting treatment chosen, whether it’s deferred income or a financial liability, in your financial statement disclosures. It is also important to check HMRC guidance on how these grants might interact with R&D tax relief claims.

United States (US GAAP)

For US companies, the landscape is different. US GAAP lacks a single standard for for-profit convertible grants; treatment is often analogized from standards for debt with conversion features (ASC 470-20) or non-profit contributions (ASC 958-605). For a venture-backed startup, the most common and defensible approach is to follow the guidance for convertible debt under ASC 470-20, which supports the liability-to-equity model described above. This is the treatment most VCs and auditors will expect to see. For specifics on US federal grants, see our guide on SBIR/STTR Accounting: Phase I and II Differences.

Bridging the Gap

If your UK-based company has US investors, they will likely want to see financials that are at least reconcilable to US GAAP. The practical consequence tends to be maintaining one primary set of books (e.g., IFRS for UK statutory filings) and understanding the key differences for investor reporting. Engaging an advisor familiar with both frameworks is highly recommended as you approach a priced round.

Key Principles for Startup Grant Compliance

Managing the conversion of a grant to equity requires diligence but follows a logical path. For founders of early-stage biotech and deeptech companies, focusing on a few core principles will ensure you stay compliant and maintain investor confidence.

First, classify the funds correctly from day one. When the cash arrives, book the grant as a liability in your accounting software. Avoid the temptation to record it as revenue, as this overstates performance and creates a problem you will have to fix later during an audit or due diligence.

Second, model the conversion and its impact on dilution before you begin your next fundraising round. Use the specific terms in your grant agreement, particularly the discount or valuation cap, to calculate the number of shares that will be issued. This ensures there are no surprises for you or your existing investors when the round closes.

Third, use the right tools for the job. While QuickBooks or Xero are perfect for daily bookkeeping, managing a multi-stakeholder cap table through successive funding rounds requires dedicated software like Carta or Pulley to avoid errors.

Finally, understand the geographic nuances. The principles are similar, but the specific rules for UK (IFRS) and US (GAAP) companies differ. As you approach a priced round, it is wise to consult with a financial advisor who understands both frameworks to ensure your reporting is sound. Continue at our Government Grants & Contract Accounting hub for additional resources.

Frequently Asked Questions

Q: What happens if the startup fails before the grant converts to equity?
A: If the company dissolves before a conversion event, the grant's status depends on the agreement. Typically, the liability remains on the books. As there is no equity to convert into, the grant provider may become a creditor in the dissolution process, though often these grants are forgiven in a failure scenario.

Q: How does a convertible grant differ from a convertible note?
A: A convertible grant is funding with an obligation to issue equity upon a future financing event. A convertible note is a loan that accrues interest and also converts to equity. The key difference is that a note is debt that must be repaid if no conversion occurs, whereas a grant typically does not require repayment.

Q: Can a convertible grant ever be treated as revenue?
A: No, not if there is an obligation to issue equity. Recognizing it as revenue would violate accounting principles by overstating profitability. The presence of a future obligation to provide shares firmly classifies the initial cash receipt as a liability, not income that has been earned by the business.

Q: Does accepting a convertible grant affect our ability to claim R&D tax credits?
A: It can. In the UK, for example, certain types of grants (notified state aid) can impact which R&D tax relief scheme a company can use. It is essential to consult with a tax specialist to understand how a specific grant interacts with innovation tax incentives in your jurisdiction to ensure full compliance.