Accounting for Underwriter Overallotment Option

Accounting for Underwriter Overallotment Option

2021-08-22T20:52:46+00:00 08/22/2021|Financial Instruments, SPAC accounting issues|0 Comments

Background

Many public offering transactions include a feature that allows the sale of additional debt or equity securities to underwriters of the offering company. The terms of the feature are that underwriters can purchase, at their discretion, specified amount of securities within certain amount of days following the transaction close at a price agreed on now. Generally, in equity offerings, the amount of additional shares issuable to underwriters is 15% of the initial offering while the option term varies between 30 and 45 days. The feature is referred to as an overallotment option and, in essence, represents a written call (purchase) option.

Historically, overallotment provisions (or a greenshoe provision) have been used to accommodate potential investor demand in excess of the base offering amount, which may not be known until the issuance date or shortly thereafter. Therefore, the option permits the issuer to issue more securities without the time and expense of an additional filing. For example, an issuer plans to issue 20 million of equity securities at $ 10 per share, yet discovers at the issuance date that there is additional demand in the marketplace for the instruments. To accommodate for this additional demands, terms of the offering include the overallotment option allowing to issue, at underwriter option, 3 million more securities at $ 10 per share during 30 days after the initial issuance.

Amount of issuable shares under some overallotment options is impacted by underwriter sale or purchase of equity securities at the open market. For example, according to terms of some overallotment options, the amount of issuable shares may be reduced by underwriter purchase of shares at the open market. The reduction may be permanent or temporary. If the reduction was temporary, the amount of issuable shares can increase to the original level, if the underwriter sells some or all of securities previously purchased at the open market.

In most cases, the exercise of overallotment option is contingent upon underwriter receipt of orders for more shares than included in the base offering.

Being a common feature in public offerings of operating companies, overallotment options are also included in public offerings by Special Purpose Acquisition Company (SPAC). Under the terms of SPAC overallotment option, underwriters will have an option to purchase additional units from the SPAC. SPAC units including common stock and warrants. If underwriters exercise their option, SPAC sponsor will also be expected to purchase additional warrants referred to as “private” at the time when underwriters exercise the option. The sponsor will purchase additional warrants at the same price (e.g. $ 1 or $ 1.5 per warrant) that it paid for the original warrants.

Many overallotment options found in SPAC offerings do not have any terms whereby the amount of issuable shares is impacted by underwriter transactions in the open market. Generally, underwriters of SPAC offerings can only exercise the option provided the amount of securities per base offering is not sufficient to satisfy all investor orders.

Many reporting entities including SPACs raised a question of how to account for underwriter overallotment option.

Executive Summary

Underwriter’s overallotment option may be classified as instrument embedded in the host securities, i.e. shares or warrants. Proponents of the above view believe that overallotment options are not considered legally detachable, i.e. underwriters cannot sell or otherwise legally transfer them. Economic characteristics and risk of embedded overallotment option are considered clearly and closely related to those of the host. Therefore, the option component is not to be bifurcated under ASC 815-15 and is accounted for as part of the host instrument. SPACs account for embedded underwriter overallotment options as part of IPO units. SPACs also account for overallotment options embedded in private warrants as part of the warrants.

Alternatively, overallotment options may be considered freestanding financial instruments. The above treatment is based on the understanding that the option may be exercised subsequent to transferring securities from underwriters to investors and that, in this case, the option should be detached from the initial securities before it is exercised. Freestanding overallotment options may also be considered subject to ASC 480 and, if so, classified as a separate liability. Such liability-classified overallotment options are measured at fair value initially and subsequently.

Freestanding overallotment options not considered in the scope of ASC 480, have to be analyzed to determine if they meet the scope exception from the application of derivative guidance. The analysis involves applying indexation guidance as well as additional equity classification requirements. If freestanding options receive the scope exception, they are reported as part of entity’s equity. In this case, equity issuance proceeds may have to be allocated to the instrument in question on a relative fair value basis. Subsequently, equity-classified overallotment options are not remeasured and are carried at the initial amount. If freestanding options do not meet derivative scope exception, they have to be the accounted for at fair value at issuance and subsequently with changes in fair value reported in earnings. The above accounting treatment is conceptually similar to the treatment under ASC 480.

Most SPACs took the position that underwriter overallotment option should not be accounted for as liabilities, separately from the host. This accounting treatment applies to overallotment options that are either a) embedded and not freestanding financial instruments; b) freestanding financial instruments outside of the scope of ASC 480 and meeting requirements of derivative scope exception.

Accounting Analysis

Overallotment options represent equity-linked financial instruments. Appendix A: Accounting for Equity-Linked Instruments shows an overall approach to accounting for overallotment options or other equity-linked instruments. At a high level, an overallotment option may have to be recognized and reported as a) part of the host instrument or b) separately per ASC 480, Distinguishing Liabilities from Equity or ASC 815, Derivatives and Hedging. Separate reporting of the option will entail measuring the option at fair value initially and subsequently with changes in fair value reported in earnings.

Topic 1: Freestanding vs. Embedded Instruments

Box A Freestanding vs. Embedded. Current accounting guidance has different set of rules applicable to so embedded and freestanding instruments.

An instrument is considered freestanding if either of the following two conditions apply (ASC 815-40-20, Glossary):

  1. the instrument is entered into separately and apart from any of the entity’s other financial instruments;
  2. it is entered into in conjunction with some other transaction and is legally detachable and separately exercisable;

A reporting entity should first determine whether the components (1) were issued contemporaneously and in contemplation of each other or (2) were negotiated separately and/or at different points in time. Overallotment options are issued in connection with the underlying securities. From this perspective, the two instruments were not entered into separately.

U.S. GAAP does not provide specific guidance on the meaning of “legally detachable.” “Legally detachable” generally refers to ability of the instrument holder to legally transfer, e.g., sale the instrument without transferring all other related instruments.

We noted two views in legally detachable and separately exercisable analysis, referred below as View 1 and View 2.

View 1 is based on the understanding that the terms of the underwriting agreement do not envisage legal transfer of the overallotment option. In other words, the option can only be exercised by underwriters. From this perspective, the option appears to be embedded in the host contract and does not represent a freestanding instrument.

The above view is supported, in part, by the following provisions of ASC 815-10-15-5:

The notion of an embedded derivative…does not contemplate features that may be sold or traded separately from the contract in which those rights and obligations are embedded. Assuming they meet [the] definition of a derivative instrument, such features shall be considered attached freestanding derivative instruments rather than embedded derivatives by both the writer and the current holder.

Proponents of View 1 believe that if an item is separately exercisable but not considered legally detachable, it would not be a freestanding financial instrument under item (b) of the definition of a freestanding financial instrument.

View 1 Conclusion: underwriter’s overallotment option is an embedded instrument.

Topic 2: Accounting for embedded instruments

If an overallotment option is considered a feature embedded in the securities initially issued, that embedded feature should be analyzed to determine if it should be bifurcated from the host instrument. That determination will involve evaluating the hybrid instrument (the security and embedded overallotment feature) pursuant to ASC 815-15.

Box C1 Fair Value Option: ASC 825-10, Financial Instruments provides reporting entities with an option to measure some financial instruments at fair value on an instrument-by-instrument basis. ASC 825-10-15-5 par. f does not allow application of the fair value option to “financial instruments that are, in whole or in part, classified by the issuer as a component of shareholder’s equity (including temporary equity)…”. IPO shares issued by SPACs and subject to redemption terms are classified as part of temporary equity. Shares issued by operating companies are commonly considered part of issuer’s permanent equity. From this perspective, reporting entities may not apply the fair value option.

Box C3 Clearly and Closely Related Evaluation: The evaluation refers to a comparison of the economic characteristics and risks of the embedded feature and those of the host. US GAAP does not offer a specific definition of clearly and closely related concept, however, it illustrates the concept through examples provided in ASC 815-15-25-23 through 50.

Generally, to be considered clearly and closely related to the host, the underlying that causes the value of embedded feature to fluctuate, must be related to the inherent economic characteristics of the host instrument. To assess whether an embedded feature is considered clearly and closely related to the host, reporting entity should first determine the nature of the host contract.

The overallotment option represents a written call or purchase option. Generally, the economic characteristics and risks of the embedded written call option are considered clearly and closely related to the economic characteristics and risks of the host contract. The underlying to the overallotment option is the same security as the host instrument.

Box C2: If the economic characteristics and risks of the embedded feature and the host are clearly and closely related to each other, ASC 815 does not require bifurcation of the feature from the host. The host (IPO units and private warrants) and the overallotment option are recorded as one instrument.

Based on the above analysis, the overallotment option would not be bifurcated from the host instrument.

Some SPAC IPO units are classified as temporary equity, based on the redemption terms and consistent with the requirements of ASC 480-10-S99-3A. We believe that the temporary equity treatment does not impact the above clearly and close related conclusion as option underlying has the same economic risk and characteristics as does the host instrument.

Option to issue additional private warrants is entered into in connection with the initial issuance of private warrants and not separately. The option is not legally transferrable, i.e. it can only be exercised by the sponsor. Additionally, transferability of private warrants is restricted until SPAC merger. Therefore, the option to purchase additional private warrants is considered an embedded and not a freestanding instrument, based on the requirements of ASC 815-40-20, Glossary.

Further, we believe that economic risk and characteristics of the option to acquired additional private warrants are clearly and closely related to the initial warrants.

Based on the above considerations, option to acquire additional private warrants is not separated from the underlying warrants.

Some reporting entities raised a question of whether the overallotment option considered a derivative financial instrument as defined in ASC 815-10. Per ASC 815-10-15-83 a derivative instrument is a financial instrument or other contract with all of the following characteristics: a) one or more underlyings, b) one or more notional amounts or payment provisions or both, c) no or limited initial net investment, d) net settlement.

The underlying of an overallotment option is the price of the underlying securities. Overallotment options have little or no initial net investment, similar to other options. The net settlement requirement is likely to be satisfied because the securities delivered upon the exercise of the option are readily convertible to cash through the market in which they are offered. However, some entities believe that overallotment options do not have a notional amount, i.e. the number of units, shares or other face amount stated in the contract. Specifically, this view applies to overallotment options where the amount of issuable securities depends on underwriter sale or purchase of securities in the open market. Since the amount of issuable securities depends on underwriter activities, the notional amount is not known. We generally believe such overallotment options do not have a notional amount and are not considered derivatives. However, in cases, when the amount of overallotment shares does not depend on underwriter market activity, the notional amount is assumed to be the contractual maximum of shares. Such overallotment options will likely be considered derivative instruments.

Conclusions: overallotment options may be considered financial instruments embedded in the host instruments e.g. shares or warrants. Economic characteristics and risk of such overallotment option are considered clearly and closely related to those of the host. Therefore, the option component is not to be bifurcated under ASC 815-15. Overallotment option is to be accounted for as part of the host instrument. SPACs account for embedded underwriter overallotment options as part of IPO units. SPACs also account for overallotment options embedded in private warrants as part of the warrants.

Topic 3: Freestanding Instruments- View 2, Scope of ASC 480

Some believe that as part of “legally detachable and separately exercisable” evaluation a reporting entity should consider whether (1) a right in a component may be exercised separately from other components that remain outstanding and (2) if, once a right in a component is exercised, the other components are no longer outstanding. Since separate exercisability invariably requires the component first be detached prior to exercise, this is a strong indicator that the components are freestanding.

As noted above, the overallotment option cannot be legally transferred from the IPO units. However, according to the terms of most overallotment options, underwriters can exercise their option even after the underlying securities are sold to investors. For example, according to standard terms of SPAC overallotment option:

“Said option may be exercised in whole or in part at any time on or before the 45th day after the date of the Prospectus upon written notice by the Representatives to the Company setting forth the number of Option Securities as to which the several Underwriters are exercising the option and the settlement date.”

Some believe that the overallotment option should be first detached from the initial shares transferred to the investors prior to exercising. From this perspective, the option to acquire additional IPO units appear to be detachable and, therefore, freestanding.

Proponents of the above View 2 believe that even though the option cannot be transferred by underwriters, the option is not necessarily embedded; it is merely attached. Supporter of View 2 believe that underwriter overallotment options are considered freestanding financial instruments.

If the overallotment option is considered a freestanding financial instrument, it has to be evaluated pursuant to ASC 480, Distinguishing Liabilities from Equity. Instruments included in the scope of ASC 480 are considered liability (or asset) instruments to be recognized and presented separately. Generally, ASC 480 applies to the following freestanding equity-linked instruments:

  • mandatorily redeemable securities as defined in ASC 480-10-25-4 through 7;
  • securities that may require the issue to settle the obligation by transferring assets as defined in ASC 480-10-25-8 through 13;
  • instruments meeting other specific requirements per ASC 480-10-25-14;

ASC 480-10-S99-3A contains additional classification and measurement requirement applicable to public companies.

According to ASC 480-10-25-8:

An entity shall classify as a liability (or an asset in some circumstances) any financial instrument, other than an outstanding share, that, at inception, has both of the following characteristics:

  1. It embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation.
  2. It requires or may require the issuer to settle the obligation by transferring assets.

ASC 480-10-25-8 does not apply to an outstanding share including share classified as temporary equity. However, ASC 480-10-25-10 specifically includes in the scope of ASC 480 forward purchase contracts or written put (purchase) options on issuers equity shares that are to be physically settled or net cash settled. According to the terms of a written put option, a reporting entity agrees to buy its own shares from a counterparty.

SPAC public shareholders may, at their option, redeem ordinary shares upon completion of business combination transaction subject to certain limitations. ASC 480 has specific provisions concerning warrants, i.e. written call options issued on contingently redeemable (puttable) stock. According to ASC 480-10-55-33:

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 480-10-25-8 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.

The above requirements cover warrants on shares that may require transfer of assets, i.e. conditional obligations, not just mandatorily redeemable shares.

According to ASC 480 measurement requirements, warrants for puttable shares are measured at fair value initially (ASC 480-10-30-7) and subsequently (ASC 480-10-35-5) with the changes in the fair value reported in earnings.

The above guidance may apply to overallotment options by analogy. The application by analogy is based on conceptually similar nature of overallotment options and warrants, both considered written call options.

Overallotment options deemed as a liability under ASC 480 are accounted for using one of the two accounting methods:

  1. based on proceeds allocated from the offering and, thus, reducing, the amount of the offering amount or
  2. as a separate instrument issued for no proceeds with the offset to expense or deferred equity issuance cost, i.e. Cr Overallotment Option Liability; Db Equity Issuance Costs or Db Issuance Expense;

Allocation of proceeds to liability-classified instruments is generally performed using “with-and-without”. Under this method, a portion of the proceeds equal to the fair value of the instrument measured at fair value is first allocated to that instrument on the basis of its initial fair value. The remaining proceeds are then allocated to the other instrument issued in the same transaction on a residual basis. The with-and-without approach avoids recognition of “day 1” gain or loss in the income statement.

Following either of the above methods, reporting entities measure the overallotment option at its fair value initially. The option is remeasured at fair value subsequently until it is exercised or expires.

We understand that the application of ASC 480-10-55-33 and ASC 480-10-25-8 by analogy to overallotment options does not represent the only established accounting method. We understand that physically settled written call options or forward sale contracts under which the issuer will deliver shares that contain an unconditional or conditional redemption obligation (e.g., shares that are redeemable upon an event that is outside the control of the issuer) might be subject to guidance applicable to contingently redeemable securities. Given the lack of specific requirements to apply the existing guidance for contingently redeemable securities to overallotment options, some reporting entities concluded that the options are outside of the scope of ASC 480. We understand that no single accounting treatment is currently established or is required by GAAP in the area of accounting for overallotment options.

If the overallotment option is not considered an ASC 480 liability, the option has to be evaluated using indexation guidance and additional equity classification requirements per ASC 815.

Box B2 Indexation Guidance: An overallotment option for equity securities may qualify for the scope exception in ASC 815-10-15-74(a) because the options are settled in the underlying equity security. The option would be classified as equity if it is both (1) indexed to its own stock and (2) classified in stockholders’ equity in its statement of financial position pursuant to ASC 815-40, Contracts in Entity’s Own Equity.

ASC 815-40-15 includes the guidance analyzing if the instrument is indexed to entity’s own stock or indexation guidance. Generally speaking, instruments are indexed to entity’s own stock when economic characteristics and risk of the instrument are similar to those of entity’s equity.

Indexation guidance requires an entity to apply a two-step approach (ASC 815-40-15-7). Step 1 covers the evaluation of instrument’s contingent exercise provisions, if any. If the evaluation of Step 1 does not preclude an instrument from being considered indexed to the entity’s own stock, the analysis shall proceed to Step 2. Step 2 of the indexation guidance is focused on the analysis of instrument’s settlement provisions. Settlement condition or a provision that affects whether the option can be exercised, such as occurrence of overallotment event, is considered an example of exercise contingency.

As part of Step 1, management should evaluate all contingencies or conditions associated with exercise of underwriter rights under the terms of the instrument. An exercise contingency shall not preclude an instrument (or embedded feature) from being considered indexed to an entity’s own stock provided that it is not based on either of the following:

  1. An observable market, other than the market for the issuer’s stock (if applicable)
  2. An observable index, other than an index calculated or measured solely by reference to the issuer’s own operations (for example, sales revenue of the issuer; earnings before interest, taxes, depreciation, and amortization of the issuer; net income of the issuer; or total equity of the issuer).

An exercise condition linked to investor orders for entity’s IPO shares is based on the market for issuer’s stock. Therefore, such an exercise condition 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 entity’s shares is exchanged for fixed monetary amount, i.e., fixed exercise price, subject to certain exceptions. The above rule is referred to as “fixed-for-fixed”.

Certain settlement adjustments impacting amount of issuable shares and settlement price may comply with Step 2 requirements. Examples include equity restructuring adjustments such as stock dividend, stock split, etc. (ASC 815-40-20, Glossary) or adjustments based on variables used as inputs to the valuation model utilized to determine the fair value of a fixed-for-fixed forward or option on equity shares (ASC 815-40-15-7E).

Generally, under the terms of SPAC underwriting agreements, additional securities are purchased at the same price per unit as the underwriters paid for the initial securities. Further, we understand that standard terms of SPAC underwriting agreements do not include substantive adjustments impacting the per unit price. In such cases, overallotment settlement provisions will not preclude equity classification. However, terms of settlement provisions applicable to issuance of securities by operating companies to their underwriters should be carefully analyzed to determine if they meet the requirements of the fixed-for-fixed rule.

SPACs should also determine if settlement terms of public shares issuable under an overallotment option are consistent with Step 2 requirements. Generally, SPACs classify public shares as temporary equity, subject to certain redemption limitations stated in legal documents and consistent with the requirements of ASC 480-10-S99-3A. According to ASC 815-10-15-76:

“Temporary equity is considered stockholders’ equity for purpose of the scope exception in paragraph 815-10-15-74(a) even if it is required to be displayed outside of the permanent equity”.

Based on the above, classification of commons shares as temporary equity is consistent with Step 2 equity classification requirements for the overallotment option.

Box B4 Additional Equity Classification Requirements: Generally, additional equity classification requirements are intended to identify situations when the instrument holder can force the issuer to settle in cash and not in equity. Additional equity classification requirements are as follows:

  1. Settlement is permitted in unregistered shares;
  2. Entity has sufficient authorized and unissued shares;
  3. Contract should contain an explicit limit on the number of shares to be delivered;
  4. No required cash payment if entity fails to make timely filings with SEC;
  5. No cash-settled top-off or make-whole provisions;
  6. No counterparty rights rank higher than shareholder rights;
  7. No collateral required;

Recently issued accounting updated ASU 2020-06 eliminated conditions one, six and seven. ASU 2020-06 is effective for smaller reporting companies for fiscal years beginning after December 15, 2023. Early adoption is permitted for fiscal years beginning after December 15, 2020, as the earliest.

We understand that, in general, the amount of authorized shares at the time of the IPO was determined as such that SPACs have enough unissued shares to satisfy their obligations under underwriting agreements including overallotment options. In this case, requirement two above will be met. Overall, we understand that most SPACs will likely meet other applicable requirements, however, a careful analysis should be performed to corroborate that.

Box B5, B6: If the overallotment option receives an exception from derivative accounting, it is recorded together within reporting entity’s equity. Equity issuance proceeds may have to be allocated to the instrument in question on a relative fair value basis. Subsequently, the overallotment option is not remeasured and is carried at the initial amount. Overallotment options that do not qualify for equity classification pursuant to ASC 815 are classified as liabilities. Such instruments are measured at fair value at issuance and subsequently adjusted to fair value through earnings until the option expires or is exercised. As part of initial recognition, reporting entities should allocate IPO proceeds to the liability-classified option, thus reducing equity proceeds as reported in company’s equity, i.e. additional paid-in capital (ASC 815-15-30-2 through 30). The above accounting including the allocation method is similar to overallotment options classified as a liability pursuant to ASC 480.

Conclusions: overallotment options may be considered freestanding financial instruments. The above determination is based on the understanding that the option may be exercised subsequent to transfer of the securities from underwriters to investors and that, in this case, the option should be detached from the initial securities before it is exercised. Freestanding overallotment options may also be considered subject to ASC 480 and, if so, classified as a separate liability. Such liability-classified overallotment options are measured at fair value initially and subsequently.

Freestanding overallotment options not considered in the scope of ASC 480, have to be analyzed to determine if they meet the scope exception from the application of derivative guidance. The analysis involves applying indexation guidance as well as additional equity classification requirements. If freestanding options receive the scope exception, they are reported as part of entity’s equity. In this case, equity issuance proceeds may have to be allocated to the instrument in question on a relative fair value basis. Subsequently, equity-classified overallotment options are not remeasured and are carried at the initial amount. If freestanding options do not meet derivative scope exception, they have to be the accounted for at fair value at issuance and subsequently with changes in fair value reported in earnings. The above accounting is similar to overallotment options classified as a liability pursuant to ASC 480.

Appendix A

Accounting for Equity-Linked Instruments

 

 


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