Convertible debt is a hybrid instrument evidencing a borrowing that is convertible into some other instrument. Traditionally, the underlying instrument into which the debt is convertible is stock; however, the conversion really could be into any type of financial other than cash, including, among other others, derivative instruments, marketable securities, or other forms of debt.
The principal characteristics of convertible debt are:
- It is a debt instrument with a maturity date and stated repayment terms;
- One party, usually the purchaser or investor, holds an option to convert the debt into some other financial instrument;
- Repayment of the debt and exercise of the conversion option are mutually exclusive. In other words, exercise of the option extinguishes the debt, and repayment of the debt cancels the conversion option.
- The conversion option is not separable from the debt. The holder cannot sell the conversion option and keep the debt.
While convertible debt can be convertible into pretty much anything, the balance of this article will address that type of convertible debt that is convertible to the company’s stock. This is in part due to the fact that the accounting guidance is specific to convertible debt that is convertible to stock. However, the guidance would apply equally to any other type of convertible debt. As always, the substance of the transaction is important, not the form.
The conversion option will typically reflect either a fixed conversion price or a price that is determined based upon a fixed discount to the market price of the stock. Investors are creative, of course, so these typical terms can be altered. It is not unusual to see conversion prices and discount percentages that ratchet, usually downward, based on contingent events (e.g., government disapproval of a drug) or an IPO at a specified price target or range, or that are tied to specified operational measures such as sales or net profit. Conversion can also be adjusted for other factors like adjustments to offset the effect of normal dilutive events (stock dividends, stock splits), subsequent issuances of equity securities at effective prices that are lower than the conversion price. This last adjustment is frequently referred to in agreements as an ‘anti-dilution’ adjustment. This is a misuse of that term. Anti-dilution is intended to offset the effects of dilution applicable to all holders of similar securities. An adjustment based on a subsequent financing is down-round price protection and places the holder in a better position relative other security holders. This is a critically important distinction when it comes to accounting as you will see.
Accounting for a convertible debt instrument begins with obtaining a thorough understanding of all key terms. If there are any terms that are confusing or vague, discuss them with the parties who negotiated or the company’s attorney. While most agreements provide very specific definitions of terms and calculations, they may still be confusing or simply Wall Street jargon that you are not familiar with.
Conventional Convertible Debt
Assuming you’re ready to dive in, and also assuming you are not going to make the fair value election under ASC 820, begin analysis of the convertible debt by evaluating the convertible debt instrument as a whole to determine if it is conventional convertible debt. In most cases you would start the analysis with the derivative accounting guidance, but conventional convertible debt holds a unique place in convertible instrument accounting in that it is a grandfathered concept given special status in derivative accounting. While the conversion option may meet the definition of a derivative, there is a specific scope exception afforded any embedded feature that is considered indexed to the company’s own stock and can be classified in equity. The conventional convertible debt criteria are such that if met, the conditions for this scope exception are also met. The conventional convertible debt criteria are:
- The holder may only realize the value of the conversion option by exercising the option and receiving the entire proceeds in a fixed number of shares or the equivalent amount of cash determined at the discretion of the issuer. While the criteria require that there be a fixed number of shares, standard anti-dilution provisions are permitted even though they would change the number of shares issuable. The important distinction from other conversion price adjustments is that standard anti-dilution provision serve merely to maintain the value of the conversion option. All others are prohibited. Provisions that are sometimes referred to as ‘anti-dilution’ but that are actually price protection provisions are NOT permitted.
- The ability of the holder to exercise the conversion option must be based on either the passage of time (immediately convertible would qualify) or the occurrence of a contingent event.
These two criteria are all that are required. The problem, however, is that adjustments for subsequent down-round financings, so-called “ratchet anti-dilution” adjustments, are very, very common. Additionally, it is usually the holder of the convertible debt that holds the choice of cash or share settlement, not the issuer. So, while the criteria are not complex or numerous, the practical reality of how these deals are structured makes them hard to meet.
The next level of evaluation takes you into the analysis for a potential embedded derivative under ASC 815. The derivative rules are very complex but can be summarized as follows:
As if freestanding
Evaluate the conversion option as though it is a freestanding instrument. The ACS 815-15-25-1 states that one of the criteria of an embedded derivative is that, “A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument [in its entirety] subject to the requirements of this Subtopic.”
Accounting definition of a derivative
Begin the embedded derivative analysis by determining whether the conversion option meets the accounting definition a derivative. There are three criteria to the accounting definition:
- a) Is there i) an underlying and ii) a notional, a payment provision, or both?
- b) Is there no or a relatively small initial investment?
- c) Is there net settlement?
These criteria are not immediately easy to grasp and there is a significant amount of discussion in Subtopic 815-10 (starting at ASC 815-10-15-83) about how to apply these criteria. Several readings may still leave you scratching your head. Fear not…the equity-linked transaction analysis tool on this site was developed for this specific reason. Use it.
If the accounting definition is met, then the conversion option is an embedded derivative.
Scope exception – clearly and closely related to the debt host contract
3) The derivative accounting guidance provides a scope exception to its accounting requirements if the conversion option is considered to have risks and characteristics that are clearly and closely related to the host contract. The host contract is a debt instrument, so to meet this scope exception the conversion option must also have debt-like risks and characteristics. The best way to determine this is to look at how the fair value of each instrument would relative to each other. The debt host’s fair value will move primarily as a function of interest rates. As interest rates rise, the fair value of the note will fall, and as rates fall, the reverse occurs. The value of the conversion option will move depending upon its structure. If the option is convertible into a variable number of shares based on a conversion price pegged to the stock price (as stock price increases, the conversion price increases and the holder receives fewer shares, and the reverse holds true for price decreases), then the conversion option is debt-like in nature since the value of the shares will always be fixed. Ignoring cost to dispose of the stock, the hold would be indifferent as to whether settlement is in shares or stock. Pretty much any other option structure will be more equity-like and less debt-like. If the number of shares issuable is fixed or if the conversion price is tied to events or factors other than the stock price, the fair value of the option starts to behave differently relative to the fair value of the debt host. Here are some criteria to evaluate when making this clearly and closely related determination:
Additionally, while it is not strictly true in every case, it is frequently the case that if the conversion option meets the criteria for being considered indexed to the company’s own stock, then it is also usually clearly and closely related to the debt host. So, if you need additional support, have a look ahead at those criteria (next).
Scope exception – indexed to own stock and can be classified in equity
If the conversion option is not considered clearly and closely related to the debt-host contract, then the next step is to determine if yet another scope exception is available. The derivative accounting guidance provides a scope exception to its accounting requirements if the conversion option is both a) indexed to the company’s own stock and b) classified in equity. The criteria for each are:
Determining whether an embedded derivative feature is linked to the entity’s own stock is a two part test:
i) The first criterion (ASC 815-40-15-7A and 7B) looks at the exercise contingencies, if any, and evaluates their nature. If there are no exercise contingencies, then the first criterion is met. However, if there are one or more exercise contingencies, they must be based solely on either 1) the market for the entity’s own stock (e.g., trading volume, closing price, average for a given time period) or 2) some observable index the is a measure solely by reference to the entity’s own operations (e.g., net income, earnings per share, revenue). If the contingency is based on any other market (e.g., S&P 500) or observable index (e.g., rate of inflation, an interest rate benchmark), then this criterion is not met. Remember, this must be a contingency based solely on some measurement of the entity itself and no other outside factor or factors regardless of how minimal. ASC 815-40-55 provides a list of example exercise contingencies and their impact under this criterion.
ii) The second criteria for determining whether an embedded derivative feature is indexed to the entity’s own stock looks at the settlement provisions; specifically, the settlement amount must be equal to the difference between the fair value of a fixed number of its shares and a fixed monetary amount or a fixed amount of debt (ASC 815-40-15-7C and 7I). At first glance this seems like a simple calculation. However, there are a number of factors that go into determining fair value. Any terms built into the settlement provisions of the instrument that affect the settlement outcome that are not also inputs to determining fair value act as a poison pill and result in the criterion not being met. This has a significant impact since settlement provisions will frequently have terms that are designed to protect the holder from downside risks. One of the most frequent provisions of this type found in an equity-linked transaction is a so-called down-round price protection provision. This can carry a number of names including ‘half-ratchet anti-dilution’, ‘full-ratchet anti-dilution’ and many others. Regardless of the name, the intent is the same…to adjust the conversion price of the instrument in the event that the entity subsequently enters into a financing at a share price lower than that of the instrument being analyzed.
If the conversion option is considered indexed to the company’s own stock, then you can evaluate the second element of the scope exception…would the conversion option be classified in equity if it were a freestanding instrument? This is a multi-criteria evaluation and is spelled out in ASC 815-40-25. This evaluation looks at the settlement terms of the conversion option with a view that any condition that might result in the company having to settle the conversion option in cash, regardless of how remote, would preclude equity classification. Going into each criteria is a lengthy undertaking and beyond the scope of this article; however, these criteria have of course been built into the equity-linked transaction evaluation tool. One other thing to note. Conventional convertible debt is specifically exempt from having to meet these equity classification criteria. It does not matter if the conversion option is an embedded derivative since by definition the conversion option in conventional convertible debt meets the requirements to be considered indexed to the company’s own stock and is exempt from the equity classification tests.
If the conversion option does not meet the criteria to be considered indexed to the company’s own stock and being classified in equity, then it must be bifurcated from the host contract and accounted for separately at fair value.
Beneficial Conversion Feature
If you have determined based upon the above that the conversion option is not subject to derivative accounting, or if the convertible debt is conventional convertible debt, then bifurcation is not required. Assuming one of those two is the case, you now need to take another look at the convertible debt to determine if there is a beneficial conversion feature (BCF). I won’t go into that here since I have already posted a detailed analysis of the BCF accounting guidance together with example calculations. I will say here, though, that if the convertible note was issued with detachable stock purchase warrants and/or any other freestanding instruments, you need to allocate proceeds to the warrant and/or other instruments BEFORE evaluating the convertible debt under the BCF rules.
After having a look at the BCF guidance and determining that it does not apply, then you are done and you can record the convertible debt as just plain vanilla debt.
You’re Not Done!
BUT, you should note that we have only addressed the conversion option. If there are other embedded features that potentially qualify as embedded derivatives, you need to evaluate each one of those separately (using the equity-linked transaction evaluation tool of course…even if not an equity-linked feature). If one or more of those requires bifurcation, you may find that you are right back in BCF accounting territory (step 5 above), or you may find that valuing the entire hybrid instrument makes more sense in terms of cost then valuing individual embedded features, or yet still you may find yourself forced to value the entire instrument at fair value if fair value of one or more of the embedded features is not reliably measurable.