Outstanding instruments — such as warrants, convertible notes, and convertible preferred stock — often have down-round protection. These provisions typically lower the strike price of the instrument or increase the conversion rate, thereby increasing the shares issued in a conversion, but could also adjust the number of shares to be issued. While characterized as “standard anti-dilution” features, down-round protection provides incremental value to investors over traditional adjustments for stock splits, dividends, and below market repurchases or issuances of equity.
Down-round protection may be provided as:
Some issuers provide down-round protection for a limited time, although protection is more commonly in effect for the instrument’s duration.
Also, the protection may exist in the instrument itself (e.g., warrant on common stock whose strike price is reduced on a down round), or in the securities underlying the instrument (e.g., convertible preferred stock underlying a warrant that has down-round protection). When a down-round occurs, the holders of the instruments with down-round protection receive disproportionately more value at the expense of the common shareholders.
To close a down-round financing, the issuer may be required to amend terms of previous preferred stock rounds or other outstanding instruments. For example, down-round protection may be added or amended to appease investors in earlier rounds; alternatively, existing shareholders may agree to reduce their economic rights in order to attract investors for the new financing round.
Below are some important accounting variables that companies should consider when issuing down-round financing:
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; that is, mark-to-market may not be required. While the existence of down-round protection alone may have precluded application of the scope exception, a recent accounting standard change reversed that position.
The new guidance provides relief for instruments with down-round protection as defined in the standard. Therefore, issuers should carefully evaluate the down-round protection mechanism to determine if it satisfies the definition, in particular for warrants. Additional criteria must be met for instruments and features to qualify for the scope exception. Issuers may not have paid much attention to these other criteria as the down-round protection on its own disqualified the instrument from the scope exception. Application of the new guidance will require a re-examination of the other criteria that were not previously considered.
For new issuances, down-round investor protection may even be a deciding factor in assessing the nature of the host contract and, in turn, could impact the embedded features that need to be separately accounted for as derivatives.
More convertible debt and convertible preferred instruments can qualify for the derivative scope exception under the new down-round guidance such that conversion rights would not be separately accounted for as embedded derivatives. However, issuers will need to consider if a down-round may adjust the conversion price to create a BCF, that is, an in-the-money conversion option.
For convertible debt that does not fall within the cash-conversion guidance, the recognition of a BCF results in incremental interest expense. Otherwise, for convertible preferred stock, the BCF results in a deemed dividend that reduces EPS.
Under the new down-round guidance, down-round protection in freestanding instruments (e.g., warrants) will impact EPS only when a down-round occurs. 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).
Valuations from appraisers likely will be needed to measure the effect of the down-round protection which is calculated as the difference between (i) the fair value of the instrument without down-round protection immediately prior to the adjustment and (ii) the fair value of the instrument without the down-round protection immediately after the adjustment.
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. 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.
Amendments to outstanding financings such as convertible debt and convertible preferred stock require determining if the amendment constitutes a modification or an extinguishment for accounting. For example, a preferred stock modification may require recognition of an immediate deemed dividend, and consequential EPS charge, for the value transferred between common and preferred shareholders.
When the market resets equity valuations, the next round of financing may be a down-round for many issuers. Consider the financial reporting impact to existing instruments with down-round protection early to help prevent surprises and filing delays if an IPO is imminent. For new instruments with down-round protection issued by both public and private issuers, there may be a path to avoid mark-to-market volatility if the financing documents are evaluated prior to closing the round. Contact your PwC advisor for assistance regarding these issues.
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Deals Managing Director, PwC US
IPO Services Co-Leader, PwC US