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Accounting impacts of a down round
Observations from the front lines
When the market resets equity valuations, new financing rounds may be “down rounds” in which companies issue stock at lower prices than previous rounds. They are typically perceived negatively and can weaken investor confidence and employee morale.
“Down round protection” is a common feature in many instruments — including warrants, convertible notes and convertible preferred stock — that limits the dilution to existing investors. But companies should consider the financial reporting impact to existing instruments with down round protection to help prevent surprises and filing delays. For new instruments with down round protection issued by both public and private issuers, there may be a path to simplify the accounting impacts if the financing documents are evaluated prior to closing the round.
What are the implications of a down round?
Down round protection provisions typically lower the exercise price of an instrument and may increase the number of shares issued upon exercise or conversion of the instrument. While often characterized as “standard anti-dilution” features by market participants, down round protection provides incremental value to investors over traditional adjustments for stock splits, dividends and below-market repurchases or issuances of equity. The accounting literature has specific guidance for down round protection that differs from more basic anti-dilution provisions.
Do you know the rules around exceptions?
Freestanding derivative instruments (e.g., warrants) and embedded derivative features (e.g., conversion option in convertible debt) that are indexed to an issuer’s own stock may be eligible for a scope exception from derivative accounting. Put another way: Mark-to-market may not be required. The accounting guidance was recently updated by FASB Accounting Standards Update ASU 2017-11 to exclude down round features from the evaluation of whether an instrument is indexed to a company’s own stock to achieve equity classification. However, careful consideration of any feature that may appear to be a down round provision must be assessed to determine whether it meets the definition of a down round provision that is eligible for this scope exception.
Further, down round investor protection embedded in hybrid preferred stock instruments may be a factor in assessing the nature of the host contract as either a debt or equity host and, in turn, could impact the embedded features that need to be separately accounted for as derivatives.
How does an accounting change impact BCF?
The accounting guidance issued in 2020 removed the beneficial conversion feature (BCF) accounting model for convertible instruments. As of the date of this publication, public companies have already adopted this accounting standard; however, private companies may not have adopted it.
If a down round provision for convertible debt and convertible preferred stock is triggered prior to adoption, issuers will need to consider if the adjustment to the conversion price results in the recognition of BCF — that is, an in-the-money conversion option.
If BCF accounting applies, then for convertible debt that does not fall within the cash-conversion guidance, the recognition of a BCF results in incremental interest expense. For convertible preferred stock, the BCF results in a deemed dividend that reduces earnings per share (EPS).
For companies that adopted the guidance issued in 2020, a down round will likely trigger other accounting, depending on the type of instrument impacted by the down round. Refer to the next discussion of deemed dividends and EPS.
Will you need an appraisal?
Down round protection in freestanding equity classified instruments (e.g., warrants) will impact earnings per share only when a down round is triggered. At that time, the down round protection value is recognized as a deemed dividend and reduces income available to common shareholders for purposes of basic EPS (a reduction to basic EPS numerator).
Under the guidance issued in 2020 that eliminated BCF accounting, the impact to convertible instruments depends on the type of instrument. For convertible debt, where the conversion option is not separated, down round provisions will no longer have any accounting impact, even when a down round occurs.
For convertible preferred stock classified in equity in its entirety, down round provisions will impact EPS only when a down round occurs, similar to freestanding equity contracts such as warrants. For mezzanine classified convertible preferred stock, the down round impact is further complicated by the interaction of the down round guidance and subsequent measurement of mezzanine equity.
Valuations from appraisers likely will be needed to measure the effect of the down round protection. For instance a valuation will be needed for a change in the fair value of a warrant or a preferred stock when a down round is triggered. Private companies that have not yet adopted the guidance issued in 2020 will need to consider retrospective application of the deemed dividend guidance for prior down round adjustments and line up valuation support as needed.
What kinds of disclosures are needed?
Companies are required to disclose terms, such as down round protection, that may change the conversion or exercise prices of financial instruments. Disclosures should describe the feature and its effect when triggered. In addition, when a down round adjustment occurs, issuers are required to disclose the down round value that is recognized in EPS.
Although the effect of a down round will no longer have an accounting impact to convertible debt, issuers are required to disclose:
- the existence of a down round provision
- any changes to conversion privileges caused by a down round provision
- the number of shares issuable upon conversion
Public companies are required to disclose the fair value of convertible instruments, which should capture the impacts of down round provisions.
Companies in the process of going public should also consider the impact to disclosures in their registration statements and subsequent periodic filings if a down round feature is triggered, such as pro forma EPS, capitalization and dilution disclosures.
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