The End of Liability Accounting for Down Rounds

Suppose a company issues a warrant or convertible note to investors. Then, sometime later, that same company issues an equity offering at a consideration per share that’s less than the current strike price of the warrant or convertible instrument. Doesn’t this dilute the ownership of the first set of investors?

Not if that warrant or convertible note has down round protection features. Commonly found in instruments that allow for the purchase of—or conversion to—equity, down round protection shelters investors from just this kind of scenario. Some features provide for a down round to partially adjust in order to compensate investors fairly for the dilution. Other features can actually leave investors better off.

The liability accounting can be tricky, however. According to GAAP, companies first need to evaluate whether the financial instrument is classified as a liability under ASC 480, Distinguishing Liabilities from Equity. If not, the next step is to determine whether the instrument or the embedded feature is classified as a derivative under ASC 815, Derivatives and Hedging.

Until last year, the existence of the down round protection alone precluded the company from qualifying for the scope exception from derivative accounting under Subtopic 815-40, Derivatives and Hedging—Contracts in Entity’s Own Equity (indexation of the instrument to the entity’s own stock). 1 Therefore, issuers had to classify the instrument as a liability and mark it to market every reporting period. That was the case whether or not the down round protection feature had been triggered—or was even likely to be triggered.

The result was that stock price increases and decreases created income statement volatility. More importantly, it was a valuation and accounting headache.

But then, on July 13, 2017, FASB revised Subtopic 815-40. Now a simple down round provision by itself no longer causes this liability treatment. Companies need to capture the impact of a down round feature only if a triggering event occurs.

If a triggering event does happen, the value of the effect of the down round feature is treated as a dividend and a reduction in net income available to common stockholders. That reflects the transfer in economic value from the issuer to the instrument holder. So what is the value of the effect of an equity-classified down round protection feature? It’s calculated as the value of the instrument with the initial strike price (before the triggering event) and the value of the financial instrument with the post-adjustment strike price. If a subsequent down round protection feature has been triggered, the company needs to determine the value of its effect without the need to perform any interim revaluations.

The upshot of FASB’s recent guidance is that most down round provisions don’t require liability treatment, sparing companies from the subsequent earnings volatility. That said, the same might not be true for certain more complicated or nontraditional down round provisions. Also, a down round might have different features that could still require equity treatment. That’s why these features require careful review of the accounting and valuation implications. Keep in mind that the number-one cause of restatements comes from misclassification of debt or equity.

Although the amendment is effective for periods beginning after December 15, 2018 for public companies, early adoption is permitted for all entities, including adoption in an interim period. In other words, if you’ve been struggling with a down round adjustment in the past, feel free to early adopt this new guidance and save yourself some hassle.

1Curious readers may note that the issuance of shares is not typically considered in option pricing models, and thus the down round protection was not considered clearly and closely related to the company’s stock, requiring bifurcation.