How down round protection clauses impact accounting for equity-linked financial instruments?
The Notion of Down Round Protection
Many companies obtain financing through more than one round of transactions in which they issue equity or equity-linked instruments. Common examples of equity-linked instruments include warrants, convertible debt or convertible preferred stock. Down round protection is a common feature in many instruments that limits the dilution of the economic interest held by the existing investors when the issuer sells new instrument at a price lower than the price of the original instrument. More broadly, the down round feature may protect from any or most reductions in the price of issuer’s shares (or equity-linked instruments) occurring subsequent to the issuance of the original instrument.
US GAAP defines a down round feature as follows (ASC 260-10-65-4):
“A feature in a financial instrument that reduces the strike price of an issued financial instrument if the issuer sells shares of its stock for an amount less than the currently stated strike price of the issued financial instrument or issues an equity-linked financial instrument with a strike price below the currently stated strike price of the issued financial instrument.
A down round feature may reduce the strike price of a financial instrument to the current issuance price, or the reduction may be limited by a floor or on the basis of a formula that results in a price that is at a discount to the original exercise price but above the new issuance price of the shares, or may reduce the strike price to below the current issuance price. A standard antidilution provision is not considered a down round feature.”
There are two main types of down round protection: weighted-average and full-ratchet. As part of full-ratchet protection, the lower subsequent price applies to the previously issued equity-linked instrument so that the amount of issuable shares under the terms of the original instrument is determined using the lower subsequent price per share. As part of the weighted-average protection, original instrument’s price is determined using the following formula:
New Price = P1 * (A + C) / (A + B), where
P1 is “old” exercise price;
A is number of shares outstanding immediately prior to new issuance on a fully diluted basis;
B is the number of newly issued or issuable shares;
C is aggregate consideration received as part of the new issuance divided by the “old” exercise price;
According to the above formula, the adjusted price is lower if a) the amount of newly issued or issuable shares is higher and/or b) the amount of consideration received as part of the new issuance is lower.
The above formula is referred to as a “broad-based” weighted average. In the “broad-based” weighted average formula, the number of shares outstanding immediately prior to the new issuance is determined on a fully diluted, or “if converted” basis. That means, that all outstanding options, warrants and other convertible instruments are considered to be converted. In a “narrow-based” version of the weighted average formula, the amount of shares outstanding immediately prior to the new issuance is determined as actual outstanding shares without giving effect to potential dilution arising from convertible instruments.
Overall, full-ratchet clauses provide investors with greater protection than weighted-average.
Classification of Debt vs. Equity
Key issue arising from accounting for equity-linked financial instruments is whether they should be accounted for as an equity or a liability instrument. The classification decision is important primarily due to the requirement to revalue liability instrument at fair value subsequent to the initial recognition with the changes in fair value reported in earnings. Liability classification may likely result in higher volatility of entity’s earnings. The classification may also increase valuation expenses.
In part, the classification decision depends on whether the instrument in question is indexed to (i.e. closely associated with) entity’s own stock. Broadly, if the instrument is indexed to entity’s stock, it is accounted for similar to stock, i.e. as part of entity’s equity. To determine if the instrument is indexed to entity’s stock, US GAAP guidance requires an entity to apply a two-step approach. Step 1 includes the evaluation of instrument’s contingent exercise provisions, if any. Step 2 is focused on the analysis of instrument’s settlement provisions (ASC 815-40-15).
As part of Step 1, management should evaluate or contingencies or conditions associated with exercise of holder’s rights under the terms of the instrument. Generally, a contingency based on reporting entity’s stock price or entity’s own operations would not preclude the instrument from being considered indexed to entity’s stock. Exercise contingency based linked to entity’s IPO or listing at “over-the-counter” market does not prevent equity classification.
As part of Step 2, management should evaluate all adjustments to instrument’s exercise price as well as the amount of issuable shares. Generally, settlement provisions will not preclude equity classification if the exchange terms are as such that fixed number of the entity’s shares is exchanged for a fixed monetary amount, subject to certain exceptions. The above rule is referred to as “fixed for fixed”.
Certain settlement adjustments designed to protect holder’s economic interest from being diluted by a transaction initiated by an issuer may pass the requirements of the “fixed for fixed” rule. The adjustments in question arise from antidilution provision as defined in US GAAP (ASC 815-40-25-41). Such adjustments include stock dividend, stock split, spin-off, rights offering or recapitalization through a large, nonrecurring cash dividend (ASC 815-40-20, Glossary).
Additionally, subjective modification provisions included in the terms of the instrument do not affect the determination of whether an equity-linked instrument is considered indexed to the reporting entity’s stock as long as the provisions in question benefit the counterparty, not the reporting entity (814-40-15-7H). For example, if management allowed to reduce the conversion rate of the debt at any point in time, this fact alone does not prevent the conversion option to be classified as equity.
Another, broader set of acceptable adjustments (or variables) impacting the exercise price or amount of issuable shares are the variables used as inputs to the valuation model applied to determine the fair value of a fixed for fixed equity-linked instruments. Examples of such inputs are risk-free interest rates, instrument’s term or fair market value of the underlying. All above variables are the inputs in the standard Black-Scholes-Merton valuation model. Adjustments to the exercise price or conversion rate linked to the above variables may not prevent equity classification.
For example, an entity may issue a warrant with the term of 7 years and the exercise price of $ 10/share at the time when shares market value is $ 10. According to the terms of the warrant, warrant’s strike price will be reduced by 5% to $ 9.5/share at the end of 5th anniversary from warrant’s issuance date provided that the warrant remains outstanding. The provision encourages warrant holders to hold their instruments for a longer period of time. In the above example, reduction in the strike price is linked to the passage of time and can be viewed as compensation for the shorter remaining term of the instrument. Since the term of the instrument is an input in the fixed for fixed equity-linked instrument, such an adjustment may not prevent equity classification.
Standard antidilution provisions, subjective adjustments and inputs used in the valuation of fixed for fixed equity instruments are the main (but not the only) adjustments that do not prevent equity classification. Other adjustments to the exercise price and/or the amount of issuable shares may result in classification of the instrument as a liability.
Revised Guidance on Down Round Protection
In July 2017 FASB issued ASU 2017-11 amending accounting for certain financial instruments with down round features.
Prior to the adoption of ASU 2017-11, instruments with down round protection provisions were not considered indexed to entity’s own stock. This was based on the fact that the issuance of another equity contract with a lower strike or conversion price is not an input to the fair value of a fixed for fixed equity linked instrument (ASC 815-40-55-33 through 34).
As part of the revised guidance, when determining whether certain financial instruments should be classified as liabilities or equity instruments, a down round feature, as defined, no longer precludes equity classification when assessing whether the instrument is indexed to an entity’s own stock.
Note that the above revision did not impact certain other equity classification requirements including seven additional requirements stated in ASC 815-40-25-10. One of the additional requirements is that the contract should contain an explicit limit on the number of shares to be delivered in a share settlement (ASC 815-40-25-10c). For example, if conversion price of debt is adjusted periodically to reflect recent changes in company’s price of stock, the conversion option may not be classified as an equity instrument as there is no limit on the amount of issuable shares. This is the case despite the fact that the adjustment provisions would qualify as a down round protection. Note that debt instruments with continuous adjustments to the conversion feature (“indexed debt”) may be subject to accounting requirements in ASC 480 or ASC 470-10-35-4.
At a conceptual level, it is possible to contemplate additional requirements of a “qualifying” down round feature that would not prevent equity classification. A hypothetical example of the additional requirement is the extent of “separability” of newly issued shares or other equity instruments from the original instrument. A lower price of a share (or other equity-linked instrument) triggering a down-round protection clause must relate to a clearly different issuance of shares, e.g. a separate round of financing. To further ensure that newly issued shares are clearly separate from the previous instruments, a hypothetical requirement might be that the entity must authorize to issue the new shares (or other equity-linked instruments) subsequent to when the original instrument was issued. Lastly, for a down round protection clause to be considered “qualifying”, newly issued shares or other equity instruments triggering the protection, must be substantively similar to the previously issued instrument.
A potential “narrower” definition contemplated above may substantially reduce the scope of application of the down round protection exception introduced by ASU 2017-11.
We noted that the definition provided by FASB does not impose additional requirements contemplated above. According to the definition, a down round protection is “a feature…that reduces the strike price…if the issuer sells shares of its stock for an amount less than the currently stated strike price of the issued financial instrument or issues an equity-linked financial instrument with a strike price below…” (emphasis is added). In other words, the definition allows the trigger of the pricing adjustment to be based on the trading of existing and previously issued shares, not additionally issued shares (or equity-linked instruments).
Similarly, FASB did not introduce any explicit requirements for how similar newly issued/traded instruments and previously sold instrument should be. We are aware that some accounting firms developed their interpretative guidance to address the above issue of “similarity”.
Under ASU 2017-11, the issuer would recognize the value of the down round protection feature i.e. settlement adjustment only when it is triggered and not before that. The impact of the triggered down round feature increases the value of the instrument that includes the feature, on the one hand and is recorded as deemed dividends, i.e. a debit to retained earnings, on the other hand. Because of the above requirement, potential impact of the feature is excluded from the initial valuation of the equity-linked instrument, i.e. the initial valuation is performed assuming that there is no feature.
ASU 2017-11 is effective for public business entities companies for fiscal years beginning after December 15, 2018 and for all other companies for fiscal years beginning after December 15, 2019. Earlier adoption is permitted.
As part of the revised guidance, when assessing whether the instrument is indexed to entity’s own stock, a down round feature, as defined, no longer precludes classification of the equity-linked instrument as equity. The definition of a down round protection is broad and does not require that the subsequent reduction in price relates to financial instruments issued subsequently to the original instrument. The revised guidance does not amend other equity classification requirements including the requirement that the contract should contain an explicit limit on the number of issuable shares (ASC 815-40-25-10c). Potential impact of the down round protection feature is excluded from the initial valuation of the instrument, i.e. the valuation is performed assuming that there is no feature.
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