Warrants on redeemable shares

Transcription

1 No October 2009 Technical Line Technical guidance on standards and practice issues Warrants on redeemable shares Contents Applicable literature... 2 What makes a share redeemable?... 4 Mandatorily redeemable securities... 4 Contingently redeemable securities... 5 Transactions within the scope of this guidance.. 7 The accounting for warrants is often complex due to both applying the accounting literature and facing challenges in understanding the related contractual provisions of the instrument. Instances in which a preferred share is treated as equity or temporary equity in the issuer s financial statements, but a warrant for such a share is required to be treated as a liability because of terms and provisions in the underlying preferred share, is a prime illustration of this complexity. This apparent inconsistency in classification is a direct result of the FASB s explicit decision to require a different accounting classification for a redeemable share (a share with an embedded redemption feature) than for a warrant (a freestanding instrument) exercisable into that very same redeemable share. This Technical Line illustrates the application of the accounting literature to freestanding warrants, and similar instruments, on redeemable shares. It also discusses the terms commonly found in preferred share agreements that result in the preferred shares being considered redeemable for classifying the warrant as a liability or equity. There is also a brief overview of the transactions where these types of warrants frequently have been issued. This and many of the publications produced by our US Professional Practice Group, are available free on AccountingLink at ey.com/us/accountinglink

2 Applicable literature The accounting for warrants on redeemable shares is included in ASC 480, Distinguishing Liabilities from Equity, and more specifically in paragraphs ASC through These paragraphs address the classification of instruments, other than an outstanding share, that have the following characteristics: The instrument embodies an obligation to repurchase the issuer s equity shares, or is indexed to such an obligation, and The instrument requires or may require the issuer to settle the obligation by transferring assets. When first read, it may not appear that these characteristics would apply to a warrant on shares. Warrants are simply written call options by which the holder can compel the issuing company to sell, rather than repurchase, its own shares. However, the phrase or is indexed to such an obligation is what brings a written call option on a redeemable share under ASC 480. It is first necessary to understand that ASC 480 uses the term obligation to refer to either a conditional or unconditional obligation to transfer assets or issue equity shares. It is also necessary to understand that this particular section of ASC 480 views the term indexed to as interchangeable with based on variations in the fair value of. Finally, it is also useful to understand that, while not defined in ASC 480, a redeemable share as used in this Technical Line generally refers to a share that either must be redeemed or may be redeemed at the option of the holder. If redemption is not certain, some may refer to those shares more generally as contingently redeemable, or puttable. (We discuss below in more detail to which redeemable shares this warrant accounting issue applies.) With those definitions in mind, one is better able to identify all the obligations that are indexed in a written call option on redeemable shares. The written call option is an obligation to issue shares conditioned on the holder exercising the option (i.e., a conditional obligation). The written call option is indexed to an underlying share (i.e., the option s value varies with the fair value of the share). If the underlying shares are redeemable, then the share itself embodies an obligation (which could be conditional or unconditional based the terms of the redemption feature) for the issuer to repurchase the share at some point after issuance. Thus, a written call option on a redeemable share is indexed to such an obligation that is, the warrant is indexed to an obligation to repurchase the share underlying the warrant. While we have focused on written call options so far, and will continue to throughout the discussion, these concepts would also apply to a forward contract requiring the company to issue redeemable shares. The FASB staff issued two rounds of interpretative guidance related to paragraph 11 of Statement 150. In October 2003, FASB Staff Position FAS 150-1, Issuer s Accounting for Freestanding Financial Instruments Composed of More Than One Option or Forward Contract Embodying Obligations under FASB Statement No. 150, provided guidance that resulted in the following instrument, used as an example in the FSP and codified in ASC , being classified as a liability: Entity B issues a warrant for shares that can be put back by Holder immediately after exercise of the warrant. The warrant feature allows Holder to purchase 1 equity share at a strike price of $10 on a specified date. The put feature allows Holder to put the shares obtained by exercising the warrant back to Entity B on that date for $12, and to require physical settlement in cash. If the share price on the settlement date is greater than $12, Holder would be expected to exercise the warrant obligating Entity B to issue a fixed number of shares in exchange for a fixed amount of cash, and retain the shares. That feature alone does not result in a liability under paragraphs through However, if the share price is equal to or less than $12, Holder would be expected to put the shares back to Entity B and could choose to obligate Entity B to pay $12 in cash. That feature does result in a liability, because the financial instrument embodies an 1 These paragraphs represent the original guidance in paragraph 11 of FASB Statement No 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, as subsequently interpreted by FASB Staff Position 150-5, Issuer s Accounting under FASB Statement No. 150 for Freestanding Warrants and Other Similar Instruments on Shares That Are Redeemable. 2 Technical Line No , 21 October 2009

3 obligation to repurchase the issuer's shares and may require a transfer of assets. Therefore, those paragraphs require Entity B to classify the warrant as a liability. A warrant to issue shares that will be mandatorily redeemable is also classified as a liability, and should be analyzed under Topic 815. The example focused on shares that can be put back to the Holder immediately after exercise and that are then puttable for a fixed price ($12 settled in cash) and established that such shares would be accounted for as a liability. Given the specificity of the example (underlying share immediately puttable for a fixed price), some questioned whether a warrant for shares that could be put back at other times, that were contingently puttable, or that could be put for a price other than a fixed price, would fall under FSP FAS and Statement 150. As a result, in June 2005, the FASB staff issued additional interpretative guidance in FASB Staff Position FAS 150-5, Issuer s Accounting under FASB Statement No. 150 for Freestanding Warrants and Other Similar Instruments on Shares That Are Redeemable. FSP FAS stated in paragraphs 5 and 6 (some footnote references omitted): 5. Paragraph 11 of Statement 150 applies to freestanding warrants and other similar instruments on shares 1 that are either puttable or mandatorily redeemable regardless of the timing of the redemption feature or the redemption price because those instruments embody obligations to transfer assets. Therefore, paragraph 11 applies to warrants on shares that are redeemable immediately after exercise of the warrants and also to those that are redeemable at some date in the future. 6. The phrase requires or may require in paragraph 11 encompasses instruments that either conditionally or unconditionally obligate the issuer to transfer assets. If the obligation is conditional, the number of conditions leading up to the transfer of assets is irrelevant. Footnote 1 to paragraph 5 of FSP FAS observed, in part, Paragraph 11 of Statement 150 requires warrants or similar instruments to acquire redeemable shares to be classified as liabilities even though the underlying shares may be classified as equity under other accounting guidance. While paragraph 5 of FSP FAS and its footnote were not included in the FASB s Accounting Standards Codification, the guidance in paragraph 6 of the FSP was included in ASC Perhaps most importantly, an example from paragraph 7 in the FSP, which illustrated the concepts in paragraph 5, was included in ASC as follows: A warrant for puttable shares conditionally obligates the issuer to ultimately transfer assets the obligation is conditioned on the warrant's being exercised and the shares obtained by the warrant being put back to the issuer for cash or other assets. Similarly, a warrant for mandatorily redeemable shares also conditionally obligates the issuer to ultimately transfer assets the obligation is conditioned only on the warrant's being exercised because the shares will be redeemed. Thus, warrants for both puttable and mandatorily redeemable shares are analyzed the same way and are liabilities under paragraphs through 25-12, even though the number of conditions leading up to the possible transfer of assets differs for those warrants. The warrants are liabilities even if the share repurchase feature is conditional on a defined contingency. This guidance clarified the FASB staff s conclusion that a warrant for a redeemable share was a liability, despite the share not being a liability itself. However, it is still counterintuitive to many companies that a warrant - to be settled by issuing a share that will be classified in equity and thus an interim step to issuing an equity instrument is itself a liability. While this seemingly inconsistent accounting treatment was raised to the FASB staff in the comment process leading up to the issuance of FSP FAS 150-5, the FASB decided to proceed with this conclusion. Technical Line No , 21 October

4 What makes a share redeemable? The warrants that most frequently fall under ASC 480, as discussed above, are warrants for preferred shares. That is because preferred shares often have triggers that allow the investor to realize the liquidation preference prior to the actual liquidation of the company. However, while we focus on preferred shares in the discussion below, these concepts equally apply to redeemable common shares. On issuance, a preferred share is analyzed under other guidance in ASC 480 to determine if it is to be classified as a liability instrument. If it is not classified as a liability, it is classified in equity. 2 For SEC registrants, that equity classification can be either as permanent equity or as temporary equity (also called mezzanine equity or the mezzanine) presented below total liabilities but not included in the subtotal for total equity. For SEC registrants make this determination using the guidance in ASC S99-3A. 3 However, the eventual balance sheet classification of the issued preferred share does not determine the classification of the warrant for that preferred share. Instead, it is the existence of any feature in the preferred share which will either automatically (unconditionally) or contingently (conditionally) require the issuer to redeem the share, or will allow the holder to compel the issuer to redeem the share (i.e., allow the holder to put the share at any time or on the occurrence of a contingent event). Mandatorily redeemable securities ASC 480 defines a mandatorily redeemable financial instrument as any of various financial instruments issued in the form of shares that embody an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur. If a preferred share is mandatorily redeemable, ASC requires liability classification for the preferred share. A warrant for a mandatorily redeemable preferred share is also a liability. However, ASC 480 does not require all shares that must be redeemed at a date certain or on an event that is certain to occur to be classified as a liability. If the instrument incorporates a term that reflects the possibility that an intervening event will prevent the share from being redeemed, then the contractual redemption, while mandatory in the context of the issuer not being able to avoid it if it occurs, is not mandatory in the context of the definition of a mandatorily redeemable financial instrument in ASC 480. For example, if a preferred share requires redemption on a date certain, but is also contractually convertible into common stock sometime prior that redemption date, the preferred shares are not considered mandatorily redeemable as redemption is actually conditioned on the shares not being converted prior to that date. 4 The preferred share is not classified as a liability under ASC 480, but rather classified in equity (or temporary equity for an SEC registrant as discussed below). However, a warrant for this share is classified as a liability because the share repurchase obligation does exist, even if it is not known whether the mandatory redemption will occur. The mandatory redemption is actually contingent on two things the exercise of the warrant into the share and the non-exercise of the embedded conversion option once the share is issued. However, as noted in paragraph 6 of FSP FAS 150-5, and carried into Codification in ASC as noted above, even if an obligation is conditional, the number of conditions leading up to the transfer of assets is irrelevant. 2 ASC 480 does not determine what instruments are classified as equity, but only that certain instruments are classified as liabilities. As stated, preferred shares not classified as a liability under ASC 480 would be classified in equity as a legal form equity instrument. 3 This guidance was originally issued by the SEC staff in EITF Topic D-98, Classification and Measurement of Redeemable Securities. EITF D-98 was initially issued in July 2001 and had been updated in a piecemeal fashion nine times since its issuance. In August 2009, the SEC staff reorganized the guidance to be more cohesive, and inserted the reorganized guidance into the FASB s Accounting Standards Codification through Accounting Standards Update No , Accounting for Redeemable Equity Instruments. 4 The example at ASC illustrates this concept. 4 Technical Line No , 21 October 2009

5 Contingently redeemable securities A preferred share that is not mandatorily redeemable may be either a) automatically redeemable on the occurrence of a contingent event and/or b) redeemable at the option of the holder either currently, or with the passage of time, or on the occurrence of a contingent event (often referred to as being puttable ). 5 Such a preferred share is not classified as a liability under ASC 480, but rather classified in equity (or temporary equity for an SEC registrant as discussed below). However, further evaluation of the trigger for the automatic or optional redemption of the contingently redeemable preferred share is necessary before concluding on the accounting for the related warrant. Understanding the nature of the contingent event that requires or allows for the redemption of an underlying preferred share is a key part of this analysis. A contingent event is usually thought of as a specific event that may or may not happen in the future. In the case of ASC 480 and warrants on contingently redeemable shares, events that trigger an obligation to redeem the underlying securities are of concern. That is, it is an event that triggers the obligation. If the future event that triggers the redemption of the preferred shares is completely within the control of the company, then actually it is the company, and not the event, that obligates itself to redeem the share. Said differently, an obligation does not exist, and will not exist, until the company triggers an event that obligates it in the future by taking an action completely within its control, or failing to take an action completely within its control, So while a contingently redeemable preferred share may be conditionally redeemable in the future, if the company controls whether those conditions are met, then despite the appearance of a contractual term whereby a contingent event triggers a redemption right, it is actually the company that controls whether or not it is obligated to redeem the share. This is regardless of the likelihood of the event occurring given the current activities, plans, or intent of the company. Contrast that preferred share with an instrument that may not be redeemable now, but will become redeemable simply with the passage of time, or on a contingent event that is not completely within the control of the issuer. In that case, the issuer is obligated to redeem when or if called upon and can do nothing to avoid the obligation. For example, consider a preferred share that is contingently redeemable on the completion of an initial public offering. A warrant for that preferred share is not a liability, as the issuer can control (i.e., avoid) triggering the redemption right in the preferred share by not initiating a public offering. In contrast, consider a preferred share that is contingently redeemable after a certain date unless an initial public offering has been completed by that date. A warrant for that preferred share is a liability because, while it is within the company s control to start the offering process, it is not within the company s control to complete an offering. As discussed above, some SEC registrants classify preferred securities the mezzanine under the guidance in ASC S99-3A. Private entities must also follow this guidance when preparing SEC-compliant financial statements (i.e., due to internal policy or for a registration statement). A conclusion under ASC S99-3A that the preferred share is classified in temporary equity (or would be classified in temporary equity if the SEC guidance was applied by a private company) generally leads to a conclusion that the warrant for the preferred share is a liability, as the preferred share is redeemable (puttable) outside the control of the issuer. 5 We collectively refer to shares that become redeemable or shares that become puttable as contingently redeemable in this section. Technical Line No , 21 October

6 A common feature in a preferred share is the redemption of the security on a deemed liquidation event. The certificate of designations, or other legal document that constitutes the preferred share, will frequently define events that trigger redemption of the preferred shareholders, yet do not represent the final liquidation of the company. Such a contractual term could be similar to the following: In the event of a liquidation, dissolution, or winding up of the Corporation, whether voluntary or involuntary, the Preferred Shareholders shall receive, from assets legally available there for and in preference to any distribution to the Common Shareholders, an amount equal to.... For the purpose of this section, a liquidation includes a deemed liquidation, which is defined as a) any transaction in which the outstanding shares of Common Stock are exchanged for consideration and the stockholders of the Corporation immediately prior to such an event hold less than 50% of the voting securities of the Corporation (or surviving entity) immediately after such event, b) Evaluating the redemption of the preferred share in the event of a deemed liquidation under the SEC s guidance requires understanding whether the transaction that gives rise to the redemption is within the control of the issuer. In cases where the issuer cannot control (i.e., cannot prevent) the occurrence of a transaction resulting in a change in the shareholders as described above (e.g., by using corporate governance provisions under its articles of incorporation, or invoking state or federal securities law), then the preferred share is classified in the mezzanine as temporary equity in SEC-compliant financial statements. A warrant for that preferred share is classified as a liability. For a private company, even if not preparing SEC-compliant financial statements, a warrant for the preferred share discussed above is still classified as a liability. The use the SEC guidance is simply a convenient rule of thumb to focus on the nature of the determination that the underlying preferred share may be redeemable outside the control of the issuer, which then affects the ASC 480 classification of the warrant. However, it is important to note that there is one instance where the SEC s guidance in ASC S99-3A results in permanent equity classification for the preferred share, yet a warrant for the preferred share is still a liability. In paragraph 3(f) of ASC S99-3A, the SEC staff provides a narrowly crafted exception from temporary classification for preferred shares when the transaction that would trigger the deemed liquidation meets certain criteria. 6 If the preferred share is considered redeemable on an event (the deemed liquidation) that can occur outside the control of the issuer, but the exception in paragraph 3(f) applies to that deemed liquidation, the preferred share is not classified in temporary equity under the SEC s guidance. However, a warrant for the preferred share is still a liability under the FASB s guidance in ASC 480. Regardless of the SEC s exception, an event could trigger redemption outside the control of the issuer. As noted above, under ASC 480, the actual balance sheet classification of the preferred share does not determine the classification of the warrant. Instead, it is the existence of any feature in the preferred share (in this case the deemed liquidation outside the control of the issuer) which will either automatically or contingently require the issuer to redeem the share. 6 The limited exception is related to how the holders of equally and more subordinated equity instruments of the issuer would be treated in the transaction giving rise to the deemed liquidation, as is more fully described in the literature cited. 6 Technical Line No , 21 October 2009

7 Transactions within the scope of this guidance Historically, we have found transactions involving warrants on redeemable shares in biotechnology or other technology companies in the start up or development stages. These companies tend to rely on preferred share issuances as a significant source of capital early in the life of the entity. In addition, these transactions may emerge in new sectors, including green technology or cleantech companies. Less frequently, more mature companies have issued these instruments. However, as result of the recent market conditions, we may see an expansion of these transactions to companies, including public companies, which may be accessing capital from new sources, such as venture funds or private equity funds that are familiar with the transactions. Finally, as noted above, the transactions in question usually involve warrants on redeemable preferred shares, but the guidance would equally apply to warrants for redeemable common shares. Your gateways to Ernst & Young technical accounting guidance AccountingLink at ey.com/us/accountinglink offers easy access to many of the publications produced by our US Professional Practice Group. AccountingLink is available free of charge. Our Global IFRS website at ey.com/ifrs offers online resources that provide more detail about IFRS, as well as issues to consider as you research the potential impact of IFRS on your company. Ernst & Young Assurance Tax Transactions Advisory 2009 Ernst & Young LLP. All Rights Reserved. SCORE No. BB1844 Ernst & Young refers to a global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm located in the US. This publication has been carefully prepared but it necessarily contains information in summary form and is therefore intended for general guidance only; it is not intended to be a substitute for detailed research or the exercise of professional judgment. The information presented in this publication should not be construed as legal, tax, accounting, or any other professional advice or service. Ernst & Young LLP can accept no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in GAAIT-Client Edition contains Ernst & Young s comprehensive proprietary technical guidance, as well as all standard-setter content. GAAIT-Client Edition is available through a paid subscription. Technical Line No , this 21 publication. October You 2009 should consult with Ernst & Young LLP or other professional advisors familiar with your 7 particular factual situation for advice concerning specific audit, tax or other matters before making any decision.