Accounting for Private Placement Financings: A Cautionary Tale

A private placement equity offering can be an attractive financing solution for companies and investors. However, after the cash hits the bank, a harrowing journey through some of the most complex and highly scrutinized areas of accounting is required; a journey where seemingly innocuous terms can have unforeseen accounting consequences that issuers may live with for years. The following is an abridged overview of the accounting requirements and an example of how a worst-case scenario could play out.

A Typical Private Placement Structure

Private placements, which are not subject to a registration statement filed with the SEC under the 1933 Act, often involve the issuance of common stock and warrants.? The warrants may come in two flavors: “Common Warrants” which have a substantial exercise price and “Pre-Funded Warrants” which have a nominal exercise price (typically, equal to the par value of the underlying Common Stock).

The Common Warrants are offered as a sweetener to investors, providing additional upside.? The Pre-Funded Warrants, on the other hand, are sold in place of the Common Stock.? Purchasing Pre-Funded Warrants allows investors to receive the economics of share ownership while avoiding certain ownership restrictions.

As an example:

• Investor A purchases 1,000 shares of Common Stock at $10.00/share and receives 500 Common Warrants as a sweetener. Total proceeds = $10,000.
• Investor B purchases 1,000 Pre-Funded Warrants at $9.99/warrant and receives 500 Common Warrants as a sweetener. Total proceeds = $9,990.

Total Proceeds: $19,990

The issuer receives nearly the same amount of consideration from each investor.? When Investor B exercises the Pre-Funded Warrants, they will pay an aggregate exercise price of $10, bringing the total cash proceeds to $10,000. ?The two investors are in nearly identical economic positions and the Company has received nearly all of the cash up front. Everyone is happy, right?? Unfortunately, it is now time to think about the accounting.

Accounting “Issues”

In our example above, the Company received $19,990.? Ignoring issuance costs and other fees, that is a debit to cash of $19,990. Easy enough. But is that the only debit we need?? And what about the credit side of the entry? There are four possible answers:?

A. Common Stock

B. Additional Paid in Capital (APIC)

C.?Liability

D.??All of the above

Step 1:? Determine the unit of account

When a company issues more than one type of debt or equity instrument in a “bundled” transaction, the first step is to determine the appropriate unit of account. This determination is governed by ASC 480, Distinguishing Liabilities from Equity (“ASC 480”), which provides guidance on identifying “freestanding” instruments. In order to be freestanding, an instrument must be both “legally detachable” and “separately exercisable.”

In most Private Placement transactions all instruments are considered freestanding, meaning that the Common Stock, Common Warrants and Pre-Funded Warrants sold to each investor are accounted for separately, rather than grouped together.? The accounting for each instrument must be separately considered.

Step 2: Determine the balance sheet classification of the Common Warrants and Pre-Funded Warrants

Both the Common Warrants and Pre-Funded Warrants are equity-linked instruments. ASC 480 and ASC 815, Derivatives and Hedging (“ASC 815), provide a complex framework to determine if liability classification is required or if equity classification is permitted.? Warrants that require liability classification are initially measured at fair value and also require remeasurement to fair value at each reporting period.

This accounting framework can be thought of as a series of traps that could trip liability classification.? It only takes one trap to trip liability classification. The level of minutia at which terms must be analyzed cannot be overstated. ?A full exploration of this guidance is outside the scope of this summary (in fact it fills hundreds of pages in the Big 4 accounting guides), but taking our example from above, let’s look at one common term.

Most Common Warrants and Pre-Funded Warrants contain a “Fundamental Transaction” provision.? This provision outlines the treatment of the warrants upon a tender offer, change or control, sale of the company or other event that fundamentally changes the equity structure of the company. While the concept is simple, these provisions are quite verbose, requiring 1,400+ words to articulate when and how these provisions would be applied. Every one of those words could trip liability classification, literally.

Let’s say that our Common Warrants and Pre-Funded Warrants have such a provision, and it provides that upon certain transactions the warrant holder will be entitled to receive consideration in an amount equal to the Black-Scholes value of the warrant.? That Black-Scholes model prescribed by the warrant utilizes a volatility assumption that is equal to the greater of 1) 100% and 2) an estimate of the current volatility at the settlement date. ?This gives the investor a little bit of protection in the event that the estimated volatility is less than 100%.? Seems pretty harmless, right?? Unfortunately, not.? Regardless of probability, regardless of materiality, this term introduces the possibility, even if remote, that the warrant holder may be entitled to receive a settlement amount that is greater than the settlement amount of a fixed-for-fixed option on the entity’s equity shares. The result: liability classification is required for the Common Warrants and Pre-Funded Warrants.? If the volatility had been defined differently (i.e., did not contain a “greater of” clause), there is a strong possibility that equity classification would not be precluded.?

Step 3: Allocation of proceeds

Now that we know the classification of the instruments, we can complete the journal entries.? Because our warrants will require subsequent mark-to-market adjustments, they will be recorded at fair value. The Common Stock will be recorded at par value and any remaining proceeds will be allocated to APIC.? We will assume the instruments have the following fair values:

• Common Stock ????????? $9.00/share
• Pre-Funded Warrant??? $8.99/warrant
• Common Warrant??????? $7.50/warrant

Investor A

Investor A did not purchase any Pre-Funded Warrants.? Here, we simply record the Common Warrants at fair value, record Common Stock at par value and the residual proceeds are allocated to APIC.

Investor B

Here we see an interesting consequence of the accounting model.? The combined fair value of the Pre-Funded Warrants and Common Stock Warrants exceeds the cash proceeds received.? Assuming this is an arm’s length transaction, this excess value is recorded as a loss.? Therefore, while the Pre-Funded Warrants are economically similar to Common Stock, they must be recorded as a liability and this requirement results in the issuer taking a loss at the issuance date.

Conclusion

While designed to provide an investment that is economically similar to direct ownership of Common Stock, the nature of the Pre-Funded Warrants can result in drastically different accounting.? In our example, the instruments issued to Investor B resulted in a loss at the issuance date that is nearly 28% of the cash proceeds received.? Further, if we assume that the underlying Common Stock doubles in value prior to the Pre-Funded Warrants being exercised, the Company would be required to record mark-to-market losses equaling $8,990.? This all stems from a definition of volatility in the warrant agreements that could easily have been changed.

As for the Common Stock Warrants, these also must be recorded as a liability and marked-to-market with changes in value recorded through earnings. Unlike the Pre-Funded warrants, these are not intended to be a stand in for Common Stock and so the liability classification and mark-to-market adjustments are somewhat more palatable. Still, simple changes can be made to achieve equity classification for these instruments as well.

The accounting framework for these instruments is an "it is what it is" model. If the warrant contains a certain term, liability classification is required. Period. It doesn't matter if all parties agree that the chance of that term being triggered is one in a million. While accounting should not drive deal strategy, issuers should work with their accounting advisors to review agreements prior to signing to ensure the best chance of a good outcome.

Over the past 14 years with CFGI I have assisted 500+ clients with the accounting for hundreds of transactions like the one described here. If you are considering a complex transaction of any kind let's talk about it! We are here to help.

Joshua Verni, National Technical Officer Leader [email protected]