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.
Don’t be fooled by the term ‘anti-dilution’. True anti-dilution provisions are considered acceptable under this criterion. ‘Anti-dilution’ when used in the context of price protection is not anti-dilution at all and is a misuse of the term. True anti-dilution is designed to offset the effects of stock splits, stock dividends and similar events. They do not improve the instrument holder’s financial or economic position. Price protection provisions, regardless of the name given, improve the instrument holder’s position relative to other instruments lacking such a provision and are therefore not anti-dilutive as that term is traditionally used.
Of all the issues related to derivative accounting, this issue has the most broad-based effect. Down-round price protection is very common in private equity financing. The price protection provisions find their way into convertible debt, convertible preferred stock, warrants and just about every other kind of instrument. These provisions violate the ‘indexed to its own stock criteria’ and cause the embedded derivative feature to be subject to derivative accounting. This is so common, in fact, that we have provided a page that provides example language to be aware of as you analyze an instrument. There are any number of reasons why an embedded derivative feature may be subject to derivative accounting. This is the most common.