No. 2009-17
11 November 2009
Technical Line
Technical guidance on standards
and practice issues
Tranched preferred share
issuances
Contents
Is the future tranche right/obligation
freestanding or embedded .................................. 2 Freestanding or embedded ............................. 2 Factors to consider in evaluating
contractual terms.................................... 3 Overview of accounting model for freestanding
instruments and embedded features ................... 3 If future tranche component is freestanding .... 3 If future tranche component is not
freestanding (is embedded)...................... 5 Recently, we have seen an increasing use of a complex financing transaction
commonly referred to as a “tranched preferred share issuance” (also referred to as a
“delayed issuance of preferred shares” or a “contingent issuance of preferred
shares”). A tranched preferred share issuance consists of multiple components, the
first of which is an initial issuance of preferred shares. The second component is
referred to as the “later” or “second” tranche or “delayed issuance.” This later
tranche (or in some cases tranches), while contractually committed to at the initial
closing date, results in preferred shares being issued at a specific future date or on
the occurrence of a future event or milestone.
Tranched preferred share transactions are commonly used by emerging biotech and
technology entities, which rely on preferred share issuances as a significant source of
capital to fund research and development and general operations. The later
tranche(s) are often timed to coincide with a future expected need for capital to
continue the entity’s product development. For example, a later tranche may be
contingent upon a biotech company commencing a certain phase of clinical trials.
While the accounting analysis for this form of financing can be complex, the first
step in the process is determining whether the future right or obligation to issue
preferred shares in a later tranche 1 is either (1) a freestanding financial instrument
requiring its own accounting or (2) a contractual feature, embedded in the
preferred shares issued at closing, which must be evaluated for potential bifurcation.
The accounting for a freestanding financial instrument and an embedded feature can
be dramatically different. Once it is determined whether the future tranche
right/obligation is freestanding or embedded, the next step involves assessing the
accounting for the combined or freestanding instruments.
This and many of the publications produced by our
US Professional Practice Group, are available free
on AccountingLink at ey.com/us/accountinglink
1
Referred to as the “future tranche right/obligation” throughout this publication.
Tranched preferred share issuances
This Technical Line addresses how to determine if the future tranche right/obligation is a freestanding instrument or an embedded
feature. It also provides factors to consider when evaluating the transaction’s contractual terms to make that determination.
Lastly, it provides a brief overview of the different accounting models applied to freestanding instruments and embedded features.
Is the future tranche right/obligation freestanding or embedded
Freestanding or embedded
The first step in accounting for a tranched preferred share issuance is determining whether there is a single instrument
(i.e., the initial issuance of preferred shares with an embedded feature providing for the future tranche right/obligation) or
multiple instruments (i.e., the initial issuance of preferred shares with a separate freestanding instrument for the future
tranche right/obligation). If the future tranche right/obligation is determined to be freestanding, then it represents a separate
financial instrument that must be evaluated for its own accounting. If, instead, it is determined that the future tranche
right/obligation is an embedded feature, that feature must be evaluated under ASC 815, Derivatives and Hedging, 2 for
potential bifurcation as an embedded derivative.
ASC 480, Distinguishing Liabilities from Equity, 3 defines a freestanding financial instrument as a “financial instrument that
meets either of the following conditions: a) it is entered into separately and apart from any of the entity’s other financial
instruments or equity transactions, b) it is entered into in conjunction with some other transaction and is legally detachable
and separately exercisable.” An instrument/feature not meeting these conditions is considered a feature embedded in another
contract or transaction.
Because both the initial issuance of preferred shares and the future tranche right/obligation are entered into at the same time
(as part of one agreement or multiple contractual agreements executed at the same time), it is the condition referred to in b)
above that must be analyzed. That is, the issuer must analyze whether the preferred shares issued at the initial close and the
future tranche right/obligation are (1) legally detachable and (2) separately exercisable.
►
Legally detachable – whether two instruments can be legally separated and transferred such that the two components may be
held by different parties. For example, if the initial investor can sell its preferred shares and retain the future tranche
right/obligation, the instruments are legally detachable. In assessing this criterion, it is not relevant which component the initial
investor can transfer. For example, if the initial investor can transfer the preferred share but contractually cannot transfer the
future tranche right/obligation, the two instruments are still legally detachable. The same would be true if the initial investor
had to retain the preferred shares but could transfer the future tranche right/obligation. As long as the investor is somehow
able to separate the two components, they are considered legally detachable.
►
Separately exercisable – whether the exercise of one instrument results in the termination of the other instrument (e.g.,
through redemption, simultaneous exercise, or expiration). For example, if the future tranche right/obligation can be exercised
while the initial preferred shares continue to be outstanding (which generally is the case with a tranched preferred share
issuance), the instruments are separately exercisable.
As mentioned previously, to conclude under condition b) above that instruments are freestanding, they must be both legally
detachable and separately exercisable. For example, if either the initial preferred shares or the future tranche
rights/obligations can be transferred to another party (separate from the other instrument), and the initial preferred shares
remain outstanding upon the exercise or fulfillment of the future tranche right/obligation (i.e., upon the issuance of the later
tranche of preferred shares), the instruments would be freestanding. However, if the future tranche right/obligation cannot be
transferred without the initial preferred shares (or the initial preferred shares cannot be transferred without the future
tranche right/obligation), yet the initial preferred shares still remain outstanding upon the exercise or fulfillment of the future
2
Primarily codified from FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, and related Statement 133 Implementation Issues.
3
Primarily codified from FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, and related
FASB Staff Positions.
2
Technical Line No. 2009-17, 11 November 2009
Tranched preferred share issuances
tranche rights/obligations, the instruments would not be freestanding. That is, the future tranche right/obligation would be an
embedded feature (i.e., embedded in the initial preferred shares).
If there are multiple future issuances or tranches of preferred shares in a tranched preferred share transaction, then the issuer
must also consider whether each subsequent issuance is an individual contractual term or a portion of a single contractual
term. For example, if a tranched preferred share issuance has a potential second, third, and fourth tranche, the issuer must
determine if there are up to three additional freestanding financial instruments or up to three embedded features for potential
bifurcation. 4 That determination is also made based on the prior framework. That is, each individual future tranche
right/obligation is evaluated under the same legally detachable and separately exercisable criteria.
Factors to consider in evaluating contractual terms
Determining whether a future tranche right/obligation is an embedded feature or a freestanding instrument involves a
thorough understanding of the contractual terms of the arrangement. The parties to the arrangement may have intended or
expected that the future tranche right/obligation would remain with the initial investor that purchased the preferred shares.
However, the legal documents (e.g., securities purchase agreement, investor rights agreement, etc.) may not require such
coupling. That is, there may be no contractual provisions in the transaction documents that prevent the initial investor from
transferring one component (either the initial preferred stock or the future tranche right/obligation) and retaining the other
component. The absence of such a contractual restriction often results in a conclusion that the future tranche right/obligation
is a freestanding financial instrument for purposes of accounting and financial reporting.
Overview of accounting model for freestanding instruments and embedded features
Once it is determined whether the future tranche right/obligation is a freestanding instrument or an embedded feature, the
accounting for the freestanding instruments (preferred share and separate future tranche right/obligation) or the combined
instrument (preferred share with embedded future tranche right/obligation) must be evaluated. In a tranched preferred share
issuance, the contractual features of the preferred shares (the first component) may vary, affecting the related accounting.
For example, the preferred share may be perpetual, contingently redeemable or mandatorily redeemable; it may be
convertible; and it may have various dividend features. In addition, the future tranche right/obligation (the second component)
may 1) mandate the subsequent round of investment, 2) give the issuer the unilateral right to force the investment or 3) give
the investor the unilateral right to invest. Each of these features and terms has a direct effect on the accounting. The following
is a brief overview of the accounting for each component at issuance, 5 but it is not an exhaustive discussion of the accounting
for all potential features and terms.
If future tranche component is freestanding
If the future tranche right/obligation is determined to be a freestanding instrument, there are two instruments for which the
accounting must be evaluated (i.e., the initial preferred shares and the separate future tranche right/obligation). The first step
is to determine the proper classification of the freestanding future tranche right/obligation instrument (as an asset/liability or
equity). This classification is important because it determines the method for allocating the arrangement proceeds between
the freestanding future tranche right/obligation instrument and the initial preferred shares. As more fully discussed below, the
accounting analysis for the initial preferred shares, in turn, depends partially on the amount of proceeds allocated to it.
A freestanding future tranche component is evaluated based on its contractual terms to determine if it is a forward contract
(the issuer must issue and the investor must purchase shares in the future, either on fixed or determinable dates or potentially
upon the resolution of future contingencies), a purchased put (issuer has the right but not the obligation to potentially issue
additional shares), or a written call (investor has the right but not the obligation to potentially purchase additional shares) on
4
5
ASC 815 requires that all embedded features be evaluated individually for bifurcation, but once those requiring bifurcation are identified, a single compound
embedded derivative is bifurcated from the host instrument (rather than individual embedded derivatives for each feature).
The detailed application of the liability and equity literature, sometimes referred to as “the roadmap,” is beyond the scope of this publication. This
publication also does not address the deferred tax accounting for differences in the tax and accounting bases.
Technical Line No. 2009-17, 11 November 2009
3
Tranched preferred share issuances
the preferred shares. The classification of the freestanding instrument is first analyzed under ASC 480 to determine if it is
classified as a liability. 6 If the freestanding instrument imposes on the issuer a conditional (outside the issuer’s control) or
unconditional obligation to issue shares that are potentially redeemable, the freestanding instrument is classified as a liability
under ASC 480.7 If ASC 480 does not require liability classification for the freestanding instrument, it is next analyzed under
ASC 815 to determine if it meets the definition of a derivative, and if so, whether it qualifies for an exception from derivative
accounting. 8 If it meets the definition of a derivative and qualifies for an exception from derivative accounting, it is classified
as an equity instrument. If it meets the definition of a derivative and does not qualify for an execption from derivative
accounting, it is classified as an asset or liability. If it does not meet the definition of a derivative, the freestanding future
tranche component is evaluated under the guidance in ASC 815-40, Derivatives and Hedging – Contracts in an Entity’s Own
Equity, which determines whether the freestanding instrument is classified as an asset or liability or in equity.
If the freestanding instrument is a liability under ASC 480, a derivative under ASC 815 (i.e., it meets the definition of a
derivative and does not qualify for the exception from derivative accounting), or an asset or liability under ASC 815-40, the
freestanding instrument is allocated its full fair value from the proceeds received at issuance (i.e., the proceeds received from
the issuance of the initial preferred shares), and is subsequently marked to fair value through earnings at each reporting
date. 9 If the freestanding instrument is classified in equity, it is allocated its relative fair value from the proceeds and is not
subsequently remeasured. At each subsequent reporting date, if the initial classification of the freestanding instrument was
determined under ASC 815 or ASC 815-40 (i.e., if classification was not determined under ASC 480), the instrument is
reevaluated to determine if the previous classification is still appropriate. 10
After the proceeds are allocated to the freestanding instrument (at either fair value or on a relative fair value basis as
discussed above), the remaining proceeds are allocated to the initial preferred shares. The preferred shares are then
evaluated to determine the appropriate accounting (e.g., classification as debt, equity or temporary equity, potential
bifurcation of any embedded features and potential beneficial conversion features). If the preferred shares are issued at a
discount due to the allocation of proceeds to the freestanding instrument (i.e., the future tranche component), the discount
can affect the accounting for any embedded redemption features (put or call options). 11 The discount might also result in a
beneficial conversion feature (a conversion option that is determined to be in the money at inception and requires separate
accounting at intrinsic value in equity) if the preferred shares are convertible. 12
6
7
8
9
10
11
12
4
ASC 480 does not determine what instruments are classified as equity, but only that certain instruments are classified as liabilities.
Issuers are often surprised to find that when a warrant or similar contract (e.g., forward contract, written call, etc.) is exercisable into a share that may be
redeemable, the classification of the warrant may vary significantly from the preferred share. For example, a warrant for an equity instrument may be
classified as a liability because the underlying equity instrument is redeemable whereas the underlying equity instrument may be classified in equity. See our
related Technical Line, “Freestanding Warrants on Redeemable Shares” (SCORE No. BB1844), issued 21 October 2009 for further discussion.
The most common exception from derivative accounting for equity derivative instruments is found in ASC 815-10-15-74(a) (formerly paragraph 11(a) from
Statement 133). That guidance provides an exception for instruments that are a) indexed to the company’s own stock and b) would be classified in equity.
The evaluation of those two criteria is addressed in ASC 815-40, Derivatives and Hedging – Contracts in an Entity’s Own Equity
This allocation method, as opposed to a relative fair value method, is preferred by the SEC staff and has been generally accepted in practice when the instrument
is subject to ongoing fair value measurements in order to avoid a day one loss on adjusting a liability from its allocated value to its full fair value through earnings.
The classification conclusion could change primarily due to changes in the issuer’s capital structure or other transactions that would affect the availability of a
sufficient number of authorized and unissued preferred shares for settlement of the future tranche right/obligation. This criterion, and others within the detailed
guidance at ASC 815-40, as well as guidance in ASC 815 on the definition of a derivative, would need to be carefully considered at each balance sheet date.
The consideration of puts and calls in host instruments is discussed in ASC 815-15-25 under separate sections related to evaluating those features in equitylike host contracts and debt-like host contracts.
Prior to Codification, EITF Issue No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion
Ratios,” and EITF 00-27, “Application of Issue 9805 to Certain Convertible Instruments,” provided guidance on the accounting for, and disclosure of,
beneficial conversion features. This guidance has been codified in ASC 470-20 under the “General” subtopics in the various sections using the headings
“Beneficial conversion features,” “Conversion features that reset,” and “Contingently adjustable conversion ratios.”
Technical Line No. 2009-17, 11 November 2009
Tranched preferred share issuances
If future tranche component is not freestanding (is embedded)
If it is determined that a future tranche right/obligation is a feature embedded in the initial preferred share, the guidance in
ASC 815 is applied to determine whether the embedded feature should be bifurcated (separated) from the initial preferred shares
and accounted for separately. That application of ASC 815, as above with a freestanding instrument, determines if the embedded
feature meets the definition of a derivative, and if so, whether it qualifies for an exception from derivative accounting.
Pursuant to ASC 815, embedded features (derivatives) are separated from their host non-derivative contracts and accounted
for as derivative instruments if, and only if, all of the following criteria are met:
►
The economic characteristics and risks of the embedded derivative are not “clearly and closely related” to the economic
characteristics and risks of the host contract.
►
The contract that embodies both the embedded derivative and the host contract is not remeasured at fair value under
otherwise applicable generally accepted account-ing principles with changes in fair value reported in earnings as they occur.
►
A separate, freestanding instrument with the same terms as the embedded derivative would be a derivative instrument
subject to the requirements of ASC 815.
When applying these criteria to a tranched preferred share issuance, the last criterion is particularly important. This criterion
requires that the embedded future tranche right/obligation feature meet the definition of a derivative under ASC 815 as if it were
a freestanding instrument. Because companies issuing tranched preferred shares are typically not publicly traded, the future
tranche right/obligation feature often does not meet the definition of a derivative in ASC 815 (i.e., it is not net settleable). In such
situations, the embedded future tranche right/obligation would not be bifurcated and would not receive separate accounting.
If a future tranche right/obligation is bifurcated, it is separated from the preferred share as an embedded derivative (along
with any other features that required bifurcation) at its fair value and classified as an asset or liability based on its terms. It is
subsequently remeasured at fair value with changes in its fair value reported in earnings in each reporting period. If it does not
meet the definition of a derivative, or does meet the definition of a derivative but qualifies for an exception from derivative
accounting, it is not bifurcated and does not receive separate accounting. In that case, there is only one instrument to account
for (the initial preferred shares), whose classification and accounting would be determined based on its terms and features.
However, at each subsequent reporting date, the bifurcation conclusion is reevaluated. 13 If a non-bifurcated embedded
feature subsequently required bifurcation, it would be bifurcated at its fair value. If a bifurcated embedded derivative would no
longer require bifurcation, it would be marked to fair value one last time and then reclassified to equity.
13
The bifurcation conclusion could change for the same reasons discussed in footnote 10.
Your gateways to Ernst & Young technical accounting guidance
Ernst & Young LLP
AccountingLink at ey.com/us/accountinglink offers easy access to
many of the publications produced by our US Professional Practice
Group. AccountingLink is available free of charge.
Assurance | Tax | Transactions | Advisory
Our Global IFRS website at ey.com/ifrs offers online resources that
provide more detail about IFRS, as well as issues to consider as you
research the potential impact of IFRS on your company.
SCORE No. BB1858
H
© 2009 Ernst & Young LLP.
All Rights Reserved.
Ernst & Young refers to a global organization of member firms of Ernst & Young Global Limited, each of which
is a separate legal entity. Ernst & Young LLP is a client-serving member firm located in the US.
This publication has been carefully prepared but it necessarily contains information in summary form and is
therefore intended for general guidance only; it is not intended to be a substitute for detailed research or the
GAAIT-Client Edition contains Ernst & Young’s comprehensive
exercise of professional judgment. The information presented in this publication should not be construed as
legal, tax, accounting, or any other professional advice or service. Ernst & Young LLP can accept no
proprietary technical guidance, as well as all standard-setter content.
responsibility for loss occasioned to any person acting or refraining from action as a result of any material in
GAAIT-Client Edition is available through a paid subscription.
You2009
should consult with Ernst & Young LLP or other professional advisors familiar with your 5
Technical Line No. 2009-17,this
11publication.
November
particular factual situation for advice concerning specific audit, tax or other matters before making any decision.