Investors like protection preferences when investing in small capitalization companies. Examples of protection preferences are debt convertible at a rate based on an average stock price at a certain date or adjustments to the conversion or exercise price in a down-round within a given period. Note that part of the private placement agent compensation will include warrants with terms that mirror the warrants issued to the investors.
Although the authoritative guidance on the accounting for such transactions was issued several years ago, there is still much confusion on how to apply the proper accounting standards. Mistakes or bad judgment calls in accounting for these transactions have real-life consequences. For example, the IRS takes the position that the fair value of warrants issued to investors in connection with debt should be taxed as original issue discount (“OID”) over the terms of the debt; it also takes the position that the fair value of the warrants issued to the placement agent be taxed in the same manner as those issued to the investors. An overstatement of the fair value of the warrants and embedded conversion features can be financially detrimental to the investors and the private placement agents.
Here is a list of the top four most common errors we see in accounting for warrants and embedded conversion features:
- The issuer uses its historical volatility with an observation period that is shorter (e.g., 2 years) than the term of the financial instrument (e.g., 5 years). In related guidance, the SEC prohibits using the historical volatility in that situation-the observable period has to be at least equal to, or longer, than the term of the financial instrument (1). This is why sometimes the volatility used in the assumptions of the valuation of the warrants and embedded conversion features is more than 100%, which overstates the valuation of such financial instruments, and accordingly, the taxable amount of the OID to investors and commissions to placement agents.
- There is no weighted-average probability used for valuing down-round provisions (risk-neutral probability/default risk) resulting in overstating the derivative liabilities. Risk-neutral probability is a commonly accepted methodology to compute the down-round risk but not very well understood by small capitalization issuers and their auditors. Applying the risk-neutral probability usually results in accounting for the fair value of the derivatives associated with such warrants at a fraction of its gross fair value.
- It’s not because a debt is convertible into a variable number of shares that it results in a derivative, which is recorded at fair value, instead of its intrinsic value (which is usually lower than fair value). There are exceptions to these rules, for example, if the debt is convertible at a rate based on an average stock price at a certain date (2), including when it is convertible at a discount of such rate-.
- Some accountants/companies account for cashless exercise features of warrants as derivatives, but they aren’t. Warrants, even if they have a cashless feature, are exercisable in a number of shares of the issuer which are capped (2). Generally, only warrants with adjustments to exercise price in a down-round are subject to derivative accounting.
The overstated valuation of warrants and embedded conversion features leads to volatile results in the issuer’s financial statements as they are marked to market each quarter and as the stock price of the issuer fluctuates. Additionally, the fair value of warrants issued with debt is considered OID for US tax purposes, taxable in the hands of the note holders even if the Company didn’t take the deduction in its own tax return. If the FV of the warrants or the embedded conversion features is overstated by the issuer for financial reporting purposes, it creates an uphill battle with the IRS to avoid OID taxable in the hands of the investors.
Care should be exercised when valuing these derivatives.
- SEC Staff Accounting Bulletin NO. 114 Share-based payment
- FASB Accounting Standard (ASC) 815-40
- Custom Chrome, Inc. v. Commissioner of Internal Revenue Service, UC Court of Appeals for the Ninth Circuit, July 10, 2000