The use of tranched preferred share issuances (TPSIs), in which a company issues preferred shares and provides for the issuance of an additional tranche or tranches of preferred shares after a contingent event, appears to be increasing. Pluris has seen an increase in TPSIs by companies in the biotech, technology and pharmaceutical industries.
TPSIs are often used by private companies to fund research and development. Future tranches can be timed to coincide with an anticipated need for funding to continue product development efforts. For example, a future tranche may be contingent on a pharmaceutical company obtaining FDA approval or a biotech company beginning a series of clinical trials.Accounting rules for TPSIs are complex. The first step is to determine whether the future right or obligation to issue preferred shares in a later tranche is: (1) A freestanding financial instrument that requires its own standalone accounting, or (2) A feature buried in the preferred share agreement that must be evaluated for bifurcation from the preferred shares host contract. Accounting for a freestanding financial instrument is very different from accounting for an embedded feature.
The objective of this alert is to raise awareness among private companies about the complexities inherent in TPSIs. This alert deals with:
(1) How to determine if a future tranche right or obligation (FTRO) is a freestanding instrument or an embedded feature.
(2) Considerations when drafting and evaluating deal documents and legal agreements.
(3) A brief overview of the accounting models that can be applied.
Freestanding vs. embedded
The first step in accounting for a TPSI is to determine whether there is (1) a single instrument; for example, the initial issuance of preferred shares with an embedded provision for a FTRO, or (2) multiple instruments; for example, the initial issuance of preferred shares with a separate freestanding instrument in the form of an FTRO.
If the FTRO is freestanding, it represents a separate financial instrument that must be accounted for separately. If the FTRO is an embedded provision, it must be evaluated under ASC 815, Derivatives and Hedging, for potential bifurcation as an embedded derivative.
ASC 480, Distinguishing Liabilities from Equity, defines a freestanding financial instrument as a financial instrument that meets either of the following conditions:
1) It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
2) It is entered into in conjunction with some other transaction and is “legally detachable and separately exercisable.”
If the instrument, feature or contractual provision does not meet these conditions, it is considered to be “embedded” or buried in the contract, agreement or transaction.
Because both the initial issuance of preferred shares and the FTRO are entered into at the same time, the second condition above is the one that has to be analyzed. Companies must look at whether the preferred shares and the FTRO are both legally detachable and separately exercisable:
Legally detachable refers to whether two instruments can be legally separated and transferred in a way that the two different instruments can be held by different parties. For example, if an investor can sell preferred shares that were initially issued, but hold on to the FTRO, the instruments are legally detachable. As long as the investor is able to separate the two instruments, it is irrelevant which instrument the investor can transfer. If the preferred shares can be transferred but the FTRO can’t, the two instruments are still legally detachable.
Separately exercisable refers to whether the exercise of one instrument results in the termination of the other (for example, through redemption, simultaneous exercise or expiration). If the FTRO can be exercised while the initial preferred shares continue to be outstanding, the two instruments are separately exercisable. This is typically the case with a TPSI.
If there are multiple future issuances or tranches of preferred shares, the issuer needs to consider whether each subsequent issuance is an individual contractual term or part of a single contractual term. For example, if a TPSI has a potential second and third tranche, the issuer must determine if there are up to three additional freestanding financial instruments or up to three embedded features for potential bifurcation. If the tranches are freestanding, each financial instrument is considered to be a separate TPSI and should be evaluated under the above criteria.
Determining whether a FTRO is an embedded feature or a freestanding instrument requires a deep review of the deal documents, which usually consist of articles of incorporation, a preferred share agreement, a purchase agreement, an investor rights agreement and, in some cases, a collaborative agreement with a related party.
The parties to the FTRO may have intended for it to remain with the initial investor that purchased the preferred shares. However, the deal documents may not explicitly require it. In other words, there may be no contractual provisions in the transaction documents that prevent the initial investor from transferring one element (either the initial preferred stock or the FTRO) and retaining the other. The absence of such a contractual restriction supports the conclusion that the FTRO is a freestanding financial instrument.
Once it is determined whether the FTRO is freestanding or embedded, the accounting for the freestanding instruments (preferred shares and separate FTRO) or the combined instrument (preferred share with embedded FTRO) must be evaluated.
In a TPSI, terms can vary. For example, the preferred share may be perpetual, contingently redeemable or mandatorily redeemable. Shares also may have different dividend features. In addition, the FTRO may (1) drive future rounds of investment, (2) give the issuer the unilateral right to force the investment or (3) give the investor the unilateral right to invest.
If FTRO is freestanding
If the FTRO is determined to be freestanding, there are two instruments to evaluate - the initial preferred shares and the FTRO. The first step is to determine the classification of the freestanding FTRO as an asset or liability, or in equity. Classification will drive the method for allocating proceeds between the freestanding FTRO and the initial preferred shares.Terms of the freestanding FTRO are evaluated to determine which of the following it is: (1) A forward contract, in which the issuer must issue and the investor must purchase shares in the future, either on fixed or determinable dates, or upon the potential resolution of future contingencies; (2) A purchased put, in which the issuer has the right, but not the obligation, to issue additional shares, or (3) A written call on the preferred shares, in which the investor has the right, but not the obligation, to purchase additional shares. The accounting classification of the freestanding instrument is first reviewed under ASC 480 to see if it should be classified as a liability. If the instrument holds the issuer to an obligation to issue shares that are potentially redeemable, the instrument is classified as a liability. It doesn’t matter whether the obligation is conditional or unconditional, as long as it is outside the issuer's control. If ASC 480 does not require liability classification, the freestanding instrument is next analyzed under ASC 815 to see if it meets the definition of a derivative. If it does, it may qualify for an exception from derivative accounting. If an exception can be applied, the freestanding instrument is classified in equity. However, if it meets the definition of a derivative and does not qualify for an exception, it is classified as an asset or a liability. If it does not meet the definition of a derivative, the instrument is evaluated under ASC 815-40, Derivatives and Hedging – Contracts in an Entity’s Own Equity, which determines whether it should be classified as an asset or liability, or in equity.
Whether it’s determined to be a liability under ASC 480, a derivative under ASC 815 that does not qualify for an exception, or an asset or liability under ASC 815-40, the instrument is allocated its full fair value from the proceeds received at initial issuance. It is subsequently marked to fair value through earnings at each reporting date. If it is classified in equity, it is allocated its relative fair value from the proceeds and subsequently remeasured. At each reporting date, if the initial classification of the freestanding instrument was determined under ASC 815 or ASC 815-40 (that is, classification was not determined under ASC 480), the instrument is reevaluated to determine if the previous classification is still appropriate.After proceeds are allocated at either fair value or on a relative fair-value basis, the remaining proceeds are allocated to the initial preferred shares. The preferred shares themselves must then be evaluated for classification as debt, equity or temporary equity, and for the potential bifurcation of any embedded instruments or beneficial conversion features. If the preferred shares are issued at a discount due to the allocation of proceeds to the freestanding future tranche, that discount can affect the accounting for any embedded redemption features, such as put or call options. The discount may also result in a beneficial conversion feature if the preferred shares are convertible and if the conversion option is in the money at inception; such cases require separate accounting at intrinsic value in equity.
If the FTRO is embedded, not freestanding
If the FRTO is a feature embedded in the initial preferred shares, the guidance in ASC 815 is used to determine whether it should be bifurcated from the initial preferred shares and accounted for separately. This analysis will help determine if the embedded feature meets the definition of a derivative and whether it qualifies for an exception from derivative accounting if it does meet the definition.
According to ASC 815, embedded features are analyzed separately from their host contracts and accounted for as derivative instruments if all of the following criteria are met:
(1) 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.
(2) The host contract that holds the embedded derivative is not already being remeasured at fair value, such as through the fair-value option election, with changes in fair value being reported in earnings.
(3) A theoretical separate, freestanding instrument with the same terms as the embedded derivative would meet the definition of a derivative instrument and would be subject to the requirements of ASC 815.
When applying these criteria to a TPSI, the third criterion can be the most challenging. It essentially requires that the embedded FTRO meet the definition of a derivative, as if it were a freestanding instrument. Because companies issuing TPSIs are usually not publicly traded, the FTRO often does not meet the definition of a derivative in ASC 815, because it cannot be net settled, which is one of the fundamental criteria that defines a derivative. As such, the embedded FTRO would not be bifurcated and would not require separate accounting.If an FTRO is bifurcated, it is separated from the preferred shares and treated as an embedded derivative (along with any other features that may require bifurcation; there are often many) at its fair value and classified as an asset or liability based on its terms. It is subsequently remeasured at fair value with changes reported in earnings at 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 require separate accounting. In this case, there is only one instrument to account for - the initial preferred shares, whose classification and accounting would be determined based on the shares’ terms. At each subsequent reporting period, the bifurcation conclusion is reevaluated. If a non-bifurcated embedded instrument were to subsequently require bifurcation, such as through an amendment to the deal documents, it would be bifurcated at its fair value. If a bifurcated, embedded derivative no longer requires bifurcation, it should be marked to fair value one last time and then reclassified to equity. Valuation Several valuation issues should be considered, including which instruments may be required to be fair valued and how to allocate preferred-share issuance proceeds among instruments (full fair value vs. relative fair value basis). Other features embedded within the preferred shares may also require valuation. If the instruments are freestanding, both the preferred shares and the FTRO must be assigned a fair value, as the preferred shares issued do not reflect a stated price, due to the inclusion of an FTRO or FTROs. Derivatives are generally fair valued through earnings at each reporting period, unless they qualify for special hedge accounting treatment. Instruments classified in equity are generally not fair valued. Valuing shares of a private company can be challenging due to a lack of information. Where valuation is required, the methodology applied is a present value model that must be revised at each reporting period for changes in present value assumptions and parameters. Changes in the fair value of the underlying shares are not factored in. We hope you have found this brief overview of TPSIs and FTROs helpful. If your company is considering a TPSI for financing, please contact us at 212 248-4500. We will be glad to help you through the accounting and valuation complexities.