- By Blue Abaco Consulting
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It’s important for management to understand the potential accounting issues that could arise from issuing equity-linked financings. These types of financings are commonly used by companies in order to raise funds so they can expand their business. However, management may not always understand that certain terms included in the financing agreements could cause unintended accounting consequences.
- Convertible instruments with a variable conversion feature or “down-round” protection (clauses which will reduce the conversion price if they subsequently issue shares of stock for a lower price) could cause the conversion feature to require liability classification.
- Warrants that contain “down-round” protection or provisions which could require the Company to pay cash to the investor in the future often cause the warrants to require liability classification.
- Preferred stock may require classification in equity, liabilities or temporary equity (“mezzanine”) depending on the specific terms of the agreement.
- If the Company doesn’t have sufficient authorized and unissued shares to meet all their equity-linked obligations then equity-linked instruments, such as convertible financings and warrants that may have originally been afforded equity classification, may need to be reclassified as liabilities.
When an equity-linked financing requires liability classification, it’s recorded at fair value and marked to fair value through earnings each reporting period. This can be quite a time-consuming and expensive task for the Company due to the valuation techniques required to estimate the fair value of these types of instruments. Determining the appropriate accounting and valuation for equity-linked instruments can be complex. To prevent any last minute accounting “surprises” it’s important for management to understand the potential effect on their financial statements before finalizing these types of transactions.