Founder Shares Transferred to Anchor Investors

Accounting for SPAC Founder Shares Transferred to Anchor Investors

Background

A SPAC or a special purpose acquisition company is a shell company listed on a stock exchange with the purpose of acquiring a private company and, therefore, making it public without going through the traditional IPO process. SPAC is registered with the SEC and is a publicly traded company.

As part of SPAC’s formation, the newly formed entity issues its founders or sponsors shares in exchange for nominal amount of equity capital, e.g. $ 25,000. In many cases, the amount of founder shares issued and outstanding is determined to be 20% of total common shares after closing of the IPO transaction, excluding impact of warrants. Sponsors may also provide the SPAC with debt financing. Debt and equity capital are used to fund entity’s formation and the cost of the initial IPO.

As part of the IPO, SPACs issue units to public investors. One unit consists of one common share and one or a fraction of a warrant. Warrants issued to public shareholders give SPAC’s shareholders an option to buy additional shares of the entity in the future at the price stated in the warrant agreement. The warrants issued to public shareholders are referred to as “public”. In connection with the IPO, SPACs also issue warrants to its founders, referred to as “private” warrants. Private warrants are generally sold to the sponsor at $ 1.0 or $ 1.5 per warrant.

Founder common stock and common shares sold to public shareholders have different rights and privileges. Public shareholders can redeem their shares for cash in connection with the proposed merger transaction or, upon SPAC liquidation, if the merger transaction did not take place. Generally, founder shares are non-redeemable. Founder shares are also subject to certain transfer restrictions.

Some SPAC public offering transactions include an arrangement involving anchor investors. Anchor investors are typically known and respected investment firms (e.g. BlackRock, Inc.). Their involvement with the IPO transaction intended to build other investors’ confidence in the issuer and the transaction in question.

A typical arrangement involving anchor investors include the following terms:

SPAC may sell, through its underwriters, to anchor investors specified amount of SPAC units;
If anchor investors purchase specified amount of SPAC units, the sponsor will also sell to the investors an agreed-on amount of founder shares;

Generally, anchor investors purchase SPAC units at the same price paid by other investors purchasing the units as part of the IPO.

In many cases the price paid by anchor investors for founder shares is the issuance price of the shares originally paid by the sponsor. Generally, the price is lower than estimated market value of the shares.

According to the terms of some deals, SPAC may also sell to anchor investors private warrants. Anchor investors pay the same price for private warrants that is paid by the sponsor.

Transfer of founder shares between the sponsor and anchor investors is the transaction between SPAC shareholders and does not directly involve the reporting entity.

Many SPACs raised a question of how to account for sponsor’s transfer of founder shares to anchor investors.

Although our analysis is performed in relation to SPAC shares, similar consideration would apply to transactions involving operating companies.

Executive Summary

When a principal stockholder pays an expense for the company, the company should recognize corresponding expense and equity contribution from the shareholder unless shareholder’s action is caused by a relationship or obligation completely unrelated to his position as a stockholder or such action clearly does not benefit the company.

Sponsor transfers founder shares to anchor investors as part of its effort to promote SPAC’s IPO. The sponsor acts in its capacity of a shareholder and with understanding that involvement of anchor shareholders will benefit SPAC’s business. Therefore, consistent with SEC guidance in SAB Topic 5T, transfer of shares by SPAC sponsor to anchor investors may have to be reflected in SPAC’s financial statements.

Specific incremental costs directly attributable to a proposed or actual offering of equity securities incurred prior to the effective date of the offering, may be deferred and charged against the gross proceeds of the offering when the offering occurs. GAAP also requires capitalizing debt issuance costs paid to third parties that are directly related to issuing debt. Such costs are recorded as a debt discount, i.e., a reduction of the carrying or “book” value of debt.

We believe that cost incurred in attracting anchor investors by virtue of transferring sponsor shares can be considered part of specific, direct and incremental offering cost.

Although application of the specific measurement basis to sponsor shares will depend on relevant facts and circumstances, generally, we believe that measuring issuance cost represented by founder shares transferred to anchor investors at shares fair value is appropriate. Specifically, the value of issuance costs will be determined as follows:

Estimated FMV of Founder Shares less Cash Proceed Paid by Anchor Investors

Similarly, if terms of the deal include anchor investor purchase of private warrants, issuance costs may include the excess of estimated fair market value of private warrants over proceeds paid for the warrants by anchor investors.

Transfer of founder share associated with issuance of equity instruments is recorded at the time of transaction close by debiting APIC- Issuance Cost and crediting APIC- Sponsor Contribution. Therefore, the above transaction does not have any net impact on SPAC’s APIC or equity.

However, SPACs may have to allocate issuance costs associated to liability-classified warrants, if any. In this case, the allocated amount would be expensed as incurred. The following journal entry will be recognized:

Db Warrant Issuance Expense

Cr APIC- Sponsor Contribution

FinAcco’s publication Accounting for SPAC Transaction Cost provides more details about allocation of transaction cost to instruments with multiple components.

Accounting Analysis

Topic 1: Impact of Shareholder Transactions on Company’s Financial Statements

SEC accounting guidance discusses impact of certain transactions involving company’s shareholders on company’s financial statements. Specifically, SEC Staff Accounting Bulletin (SAB) Topic 5T: Accounting for Expenses or Liabilities Paid by Principal Stockholder(s) discusses a transaction where a principal stockholder settles a legal claim involving the company by transferring shares to the plaintiff. If the company had settled the litigation directly, the company would have recorded the settlement as an expense. SEC response is that the value of the shares transferred should be reflected as an expense in the company’s financial statements with a corresponding credit to contributed (paid-in) capital.

According to SEC staff, similar accounting is required for other transactions where a principal stockholder pays an expense for the company. The substance of transactions should be analyzed to determine if the economic interest holder makes a capital contribution to the reporting entity. Generally, payment of entity’s expenses is considered a capital contribution unless the “stockholder’s action is caused by a relationship or obligation completely unrelated to his position as a stockholder or such action clearly does not benefit the company.” If the transaction was considered a capital contribution, the entity should record it as such, i.e. by crediting entity’s equity account or additional paid-in capital (APIC).

SEC staff provided another example where share-based payments awarded to an employee of the reporting entity by a related party (or other holder of an economic interest in the entity) as compensation for services provided to the entity. According to ASC 718-10-15-4, such transactions between employees of a nonpublic reporting entity and the holder of an economic interest in the nonpublic entity are within the scope of stock compensation guidance. The scope inclusion does not apply if the arrangement “is clearly for a purpose other than compensation for goods or services.” When ASC 718 applies, the nonpublic reporting entity should record vested stock-based awards by debiting compensation (payroll) expense and crediting equity, i.e. APIC. The credit to APIC represents a capital contribution by a related party or shareholder to the reporting entity. According to ASC 718-10-15-4:

…The substance of such a transaction is that the economic interest holder makes a capital contribution to the reporting entity, and that entity makes it share-base payment to the grantee in exchange for services rendered or goods received. An example of the situation in which such a transfer is not compensation is a transfer to settle an obligation of the economic interest holder to the grantee that is unrelated to goods or services to be used or consumed in a grantor’s own operations.

In a number of cases, cash payments or grants of stock-based instruments are made to current or future employees in connection with a business combination. An acquirer may agree to make a payment to a selling shareholder or existing employees to incentivize their future employment with the combined company. Such contracts should be analyzed to determine if they constitute a compensation arrangement separate from the business combination. The analysis is performed using the indicators listed in ASC 805-10-55-18. If it was determined that the arrangement is compensatory, related compensation expense should be recognized in acquirer’s accounting records.

Topic 2: Accounting for Equity and Debt Issuance Cost

ASC 340-10-S99-1 states that, specific incremental costs directly attributable to a proposed or actual offering of equity securities incurred prior to the effective date of the offering, may be deferred and charged against the gross proceeds of the offering when the offering occurs. The guidance states that costs of an aborted offering may not be deferred and charged against proceeds of a subsequent offering. A short postponement (up to 90 days) does not represent an aborted offering. In a classified balance sheet, deferred offering costs are reported as part of short-term assets.

Similar to equity issuance costs, GAAP has accounting requirements for cost directly related to issuing debt. ASC 835, Interest requires capitalizing debt issuance costs paid to third parties that are directly related to issuing debt. Such costs are recorded as a debt discount, i.e., a reduction of the carrying or “book” value of debt. Debt issuance costs should be amortized as an additional interest expense using the effective interest method.

Generally, expense that may qualify for a deferral and reporting as a reduction of equity (or debt) proceeds include specific legal and accounting expenses, underwriting commission, registration fees, listing and filing, transfer agent and registrar fees. The expenses also include road show travel expenses and relevant printing and engraving expenses.

Management salaries including potential increases associated with IPO work do not qualify as specific, incremental costs directly attributable to an offering.

We understand that issuance of sponsor shares to anchor investors at nominal consideration is performed to promote SPAC offering transaction. From this perspective, cost incurred in attracting anchor investors by virtue of transferring sponsor shares can be considered part of specific, direct and incremental offering cost.

Topic 3: Measurement of Issuance Cost in Arrangements Involving Anchor Investors

Anchor investors purchase SPAC units at the same price that apply to purchases of respective financial instruments by other investors. From this perspective, anchor investors do not appear to enjoy any benefits that would not be available to other market participants. However, sponsor transfers founder shares to anchor investors in exchange for cash consideration generally considered lower than the estimated fair market value of the shares. In many cases, the purchase price equals the issuance price for sponsor shares, e.g. 0.006/share.

To develop appropriate measurement basis, some reporting entities applied accounting guidance relating to transactions with related parties. Generally, transactions with related parties are recorded at the face amount, i.e. the amount indicated in applicable legal terms (see exceptions in SAB Topic 1.B.1, Questions 3 and 4). SAB Topic 5T provides further discussion on the matter as follows:

…The staff notes, however, that FASB ASC Topic 850 does not address the measurement of related party transactions and that, as a result, such transactions are generally recorded at the amounts indicated by their terms. However, the staff believes that transactions of the type described above differ from the typical related party transactions.

The transactions for which FASB ASC Topic 850 requires disclosure generally are those in which a company receives goods or services directly from, or provides goods or services directly to, a related party, and the form and terms of such transactions may be structured to produce either a direct or indirect benefit to the related party. The participation of a related party in such a transaction negates the presumption that transactions reflected in the financial statements have been consummated at arm’s length. Disclosure is therefore required to compensate for the fact that, due to the related party’s involvement, the terms of the transaction may produce an accounting measurement for which a more faithful measurement may not be determinable.

However, transactions of the type discussed in the facts given do not have such problems of measurement and appear to be transacted to provide a benefit to the stockholder through the enhancement or maintenance of the value of the stockholder’s investment. The staff believes that the substance of such transactions is the payment of an expense of the company through contributions by the stockholder. Therefore, the staff believes it would be inappropriate to account for such transactions according to the form of the transaction. (footnotes are omitted)

Although SEC staff did not directly address the use of the measurement basis (e.g. fair value or historical cost), it indicated that “it would be inappropriate to account for such transactions according to the form of the transaction”.

With certain exceptions, US GAAP requires or allows the use of the fair value measurement basis for transactions involving reporting entity’s shares or other financial instruments. In many cases involving market transactions, such as issuance of shares in a public offering, the transactional price of a financial instrument approximates its fair value.

Although application of the specific measurement basis to sponsor shares will depend on relevant facts and circumstances, generally, we believe that measuring issuance cost represented by founder shares transferred to anchor investors at shares fair value is appropriate. Specifically the value of issuance costs will be determined as follows:

Estimated FMV of Founder Shares less Cash Proceed Paid by Anchor Investors

Similar considerations may apply to purchase by anchor investors of private warrants. If the purchase price is considered lower than estimated market value, the excess (discount) may have to be considered part of offering costs.

Topic 4: Presenting Issuance Cost in SPAC GAAP Financial Statements

Transfer of founder shares between the sponsor and anchor investors is the transition that does not involve any assets (including cash) or liabilities of the reporting entity. Therefore, many SPACs have raised a question of how offering costs associated with transfer of founder shares should be reflected in SPAC financial statements.

Since the share transfer is effective on the IPO date, the arrangement may not have any impact on SPACs primary forms included in GAAP historical financial statements filed with Form S-1.

Transfer of founder share associated with issuance of equity instruments is recorded at the time of transaction close as follows:

Db APIC- Issuance Cost

Cr APIC- Sponsor Contribution

There is no net impact on SPAC’s reportable APIC or equity.

SPAC units issued as part of IPO transaction have multiple components including common stock and public warrants. Public warrants may be classified as liability or equity instruments depending on the results of separate accounting analysis. Similarly, private warrants issued at the time of the IPO may also be classified as liability or equity instruments.

Accounting for transaction cost depends on classification of the underlying instrument. For example, transaction costs allocated to liability-classified warrants are expensed as incurred in reporting entity’s income statement. Therefore, part of issuance costs associated with transfer of founder shares to anchor investors allocated to liability-classified warrants would be recorded as follows:

Db Warrant Issuance Expense

Cr APIC- Sponsor Contribution

As treatment of transaction cost depends on classification of the underlying instrument, generally, reporting entities should allocate transaction costs related to issuance of the instruments with multiple components to the individual components. US GAAP offers limited accounting guidance on how transaction costs should be allocated between multiple components of a financial instrument. A rational approach is to allocate cost associated with an instrument containing multiple components in proportion to proceeds allocated to the respective components. Refer to FinAcco’s publication Accounting for SPAC Transaction Cost for more details about allocation of transaction cost to instruments with multiple components.

Consider the following example:

Example 1: A reporting entity issued units consisting of commons and warrants for total proceeds of $ 100 m. The entity appropriately classified common shares as permanent equity while warrants were classified as liabilities. Initial fair value of warrants was estimated to be $ 15 m.

As part of the transaction, entity’s shareholder transferred to anchor investors shares with the estimated fair market value of $ 1.025 m in exchange of $ 0.025 m of cash proceeds.

Question A: How should the entity determine total amount of transaction cost associated with transfer of shares to anchor investors?

Total transaction cost associated with the transfer of share equals to excess of shares FMV over cash proceeds or $ 1 m, i.e. $ 1.025 m – $ 0.025 m.

Question B: How should the entity allocate the transaction cost to liability-classified warrants and common shares?

Transaction proceeds allocated to common share would be $ 85 m or $ 100 m, i.e. total proceeds less $ 15 m, estimated fair value of warrants. The amount of transaction costs allocated to warrants would be $ 15 / $ 100 * $ 1 or $ 0.15 m, i.e. $ 150,000.

Transaction costs allocated to common shares is $ 1 m – $ 0.15 m or $ 9.85 m.

Question C: How should the entity recognize transaction costs allocated to multiple components?

Transaction costs allocated to liability-classified warrants will be expensed immediately. The following journal entry will be recorded:

Db Warrant Issuance Expense: $ 150,000

Cr APIC- Sponsor Contribution $ 150,000

$ 9.85 m of transaction costs allocated to equity will be recorded as a reduction of equity, i.e. APIC at the time of transaction close:

Db APIC- Issuance Cost: $ 9,850,000

Cr APIC- Sponsor Contribution: $ 9,850,000

Recognizing transaction cost allocated to the equity instrument will not have any impact on company’s total equity or its individual components.

As part of Form S-1, SPACs prepare capitalization table showing the impact of the IPO transaction on company’s capital structure including debt and equity. Generally, equity structure, as disclosed in the capitalization table, shows separate categories including APIC, Accumulated Deficit, etc. As noted above, part of transaction cost allocated to liability-classified warrants will impact SPAC’s APIC and accumulated deficit. The above impact should be appropriately disclosed in the capitalization table included in company’s Form S-1.

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