How the SEC’s SPAC Guidance Affects Warrants
Special purpose acquisition companies (SPACs) have become the next big thing in equity markets. By providing a lower-barrier alternative to IPOs, these companies have become the main way companies go public today. The market saw 248 SPAC deals last year, and over 300 have taken place already in 2021.
SPACs and Warrants
While some differences between deals exist, the overall SPAC model is simple. A company is formed and undergoes an IPO. This company, a SPAC, has limited operations and no history.
In the IPO, shares are sold to investors, and money is deposited in a trust fund. The SPAC then starts looking for a company to merge with. When the merger occurs, the SPAC will convert their shares into shares of the public company, contributing capital and—more importantly—their public listing. This allows a private company to go public with little of the time and hassle of a traditional IPO.
Like many other deals, a SPAC investment typically includes warrants. Investors get a fraction of a warrant, which will be publicly listed, as part of their equity investment. SPAC founders may invest in or receive private placement warrants as part of their consideration. These let investors increase their stake in cases of a successful acquisition. They also motivate founders to find a good acquisition target.
Liability Accounting for Warrants
On April 12, the SEC released a statement on accounting and reporting considerations for SPAC-issued warrants. The guidance suggests that a pair of common features in SPAC warrants may result in liability treatment.
The first involves warrant provisions that settle for a different amount if the issuer—rather than a third party—holds the warrants. Such cases fail to meet the indexation guidance in ASC 815 because the models referred to in the SEC’s guidance do not include terms for the identity of the holder.
The second feature involves a cash payment entitlement in excess of the stock price for warrant holders following a tender or exchange offer for the post-merger company. Because this is outside of the company’s control and does not require all holders of the underlying share, the SEC determined this caused liability treatment, even if the likelihood of such a sequence of events is remote.
In either of these cases, liability classification means the warrants are marked to market each reporting period, with changes in value flowing through earnings.
Valuing SPAC Warrants
Since SPAC warrants are new, best practices are still evolving. Even so, we believe the following considerations merit special focus. As always, the key is to capture features that provide value to a market participant.
- In most cases, public warrants become marketable shortly after the IPO. As the public market provides the best indication of value, you can use these values as the fair value of the instruments. If any contingent features need to be valued, you can break them out by modeling the traded value.
- These warrants contain a number of unique provisions based on potential outcomes for the SPACs. In many cases, outcomes may require tender offers, additional cash sales at a lower amount, or other unusual features. If these features are considered unlikely, you can exclude them from the valuation. But if they are likely, you may require Monte Carlo simulation or other tools.
- SPAC warrants are typically sold as a package with common shares. As a result, it’s necessary to confirm that the portion of a warrant combined with the stock price should be equal to the purchase price. Because the warrant value depends on the stock price, iterative modeling is needed.
- In addition to these features, the warrants may contain features conditioned only on the stock price. For example, often the company may call the warrant, effectively forcing exercise if the stock price exceeds a certain level. These components, which are typical of similar contracts, should be factored in using binomial models.
- The volatility of an option pricing model is a key input. Here, we have a holding company that will have little volatility until an exchange happens. We believe the selection should be based on the size and stage of development of other newly public companies, consistent with ASC 718 guidelines on volatility for private companies. Where a SPAC intends to merge with a company in a specific segment, this should be considered as well.
- Private placement warrants are often restricted from sale until a merger occurs. In these cases, a marketability discount may be appropriate.
Of course, we’ll be watching closely as the market evolves. Meanwhile, if you have any questions, please contact us.