Capital Raising: Are Financial Instruments Classified as Liabilities or Equity?
January 05, 2022
One of the first activities for start-ups is often capital raising. In this video, you'll learn about the different accounting ramifications for financial instruments issued to investors by start-ups and why it’s important to properly structure financial instruments upfront for accounting purposes.
Startups are usually financed with preferred stock and warrants with complex features, whereas mature entities have a mix of debt and equity securities with more standard features. However, there are some complex accounting rules under Generally Accepted Accounting Principles, also known as GAAP in the United States, to consider when determining if the classification of the instrument issued is a liability, permanent equity, or temporary equity.
It is also interesting to observe that some companies seek to avoid classifying capital securities as liabilities or within temporary equity. And the question is, why? Classification affects how the changes in fair value on the instrument are reflected in your income statement. Changes in fair value on liability classified instruments are reflected in net income. For example, as interest expands or market-to-market adjustments. Whereas, changes in fair value on equity-classified instruments are reflected in equity without affecting net income.
As liabilities, the instruments may also influence the company's credit rating, stock price, regulatory capital requirements, as well as debt covenant requirements, such as the leveraged ratios. Dividends and re-measurement adjustments on equity securities that are classified as temporary equity may also reduce an entity's reported earnings per share.
So where should we start? Accounting Standards Codification, or ASC 480, is a good starting point for data meaning whether an instrument must be classified as a liability. The relevant accounting guidance has existed for several years, without substantial recent changes. For registrants with the Securities and Exchange Commission, or SEC, are those planning to go public, other than considering whether the instruments should be classified as a liability or equity. If the instrument is classified as equity, the company also needs to consider if the instrument should be classified as permanent or temporary equity. As you can see, the evaluations may differ between private and public companies, but for today's purpose, we will just focus on private companies.
As a private startup, are there any steps that can potentially avoid liability classification for your company's preferred stock or warrants issued to investors? Please note that this is only a broad discussion today, and conclusions may vary based on specific facts and circumstances.
So the first step, is you need to consider what is the appropriate unit of accounting? ASC 480 applies to each free-standing financial instrument. In some cases, securities are issued on a standalone basis, and it is apparent that there's only one unit of account. In other financing transactions, companies may issue preferred stock with detached for warrants, which consists of two or more components. And when an entity enters into a financial transaction that includes items that can be legally detached and exercised separately, those items are considered separate, free-standing financial instruments and ASC 480 must be applied to them individually.
The next step, is to consider whether your instrument contain any obligation that may require your company to transfer cash, other assets, or variable number of equity shares. To be a liability under ASC 480, an instrument must contain an obligation that requires the issuer to transfer cash, other assets, or equity shares. For example, they have an obligation to redeem an instrument. As an example, if you are required to redeem the preferred stock from your shareholders on a specific date, the preferred stock will be classified as a liability, unless the redemption is required to occur only upon the liquidation and termination of your company. Another good example is if you issue $10,000 worth of preferred stock, and the preferred stock is a liability if you are required to issue a variable of ordinary shares to satisfy the fixed amount of $10,000, in this case.
One last example is, if there is an obligation on your company to repurchase your equity shares, this may also lead to liability classification. The last step is to consider if an obligation exists, is it unconditional? as defined on the guidance obligation can broadly include any conditional or unconditional duty or responsibility to transfer assets onto issue equity shares. Conditional obligations are treated differently from unconditional obligations. If an instrument that is a share in legal form contains an unconditional obligation of the issuer to redeem it in cash, assets, or a variable number of equity shares, the instrument may be considered a liability under ASC 480. However, if the obligation to redeem from your shareholder is only conditional, for example, contingent upon the departure of one of the founders, this will not be considered a liability until the event becomes certain to occur. And this should also be reevaluated every recording period.
When setting up a new business and determining your capital structure, please reach out to your lawyers and accountants. After all, the goal is to present quality as well as accurate financial statements to your investors. Know that we are here to help. If, if any questions, please reach out to start the conversation with us.
Transcribed by Rev.com