Drafting Considerations for Attorneys Blog Series – Debt Issued With Warrants and Convertible Debt
By Sean R. Saari, Partner, Advisory Services
The fields of law, accounting and valuation continue to grow ever-more complex. Given the overlap in these specialty areas, it is increasingly important for attorneys to understand the accounting, tax and valuation effects of the legal agreements they draft. Armed with this knowledge, attorneys can deliver intended outcomes for their clients and minimize unintentional consequences and compliance burdens.
Debt Issued with Warrants
Warrants are similar to stock options – they allow the holder to purchase a certain number of shares at a certain price over a particular time period. Debt is sometimes issued with warrants to purchase shares of the borrower’s stock – typically at a discounted exercise price from fair market value. The warrants give the lender an equity upside in the company in addition to the interest earned on the debt agreement.
GAAP requires that a debt discount be established based on the fair value of the warrants issued in connection with a debt issuance. Because warrants are similar to stock options, they are often valued using a Black-Scholes model. It should be noted that many warrants are issued with $0.01 strike prices, which makes their value nearly identical to the underlying per share value when run through an option pricing model.
A number of factors influence whether the fair value of the warrant is recorded as equity or a liability and there are differences in the accounting based on the classification. The most significant difference is the fact that warrants accounted for as liabilities must be adjusted to fair value every reporting period, which requires periodic valuations of the company and the warrants. This periodic valuation requirement is a hidden compliance expense associated with issuing debt with warrants. The provision in a warrant agreement that most often triggers liability treatment is allowing the warrant to be settled in cash, so make sure that this is discussed with the company and its auditors before including/excluding this language so that the desired accounting outcome is achieved.
Convertible debt allows a debtholder to convert debt principal into an equity ownership interest and serves as another method to give the lender an equity upside in the borrower. If the conversion provisions create a “beneficial conversion feature” (“BCF”) according to the accounting guidance, a debt discount must be established equal to the value of the BCF. This is a complex area of GAAP, but basically, a beneficial conversion feature is present when the lender can purchase shares at a price below fair market value. It should be noted that if warrants are issued as well, it has a compounding effect on the value of any beneficial conversion feature that may be present, which may lead to a larger debt discount being recorded.
Our E-book, Valuation Considerations When Buying or Selling a Business – Part 2, includes all of the blogs in this series.