Why Is Accounting for Convertible Debt So Hard?
September 09, 2021
By Stephen Doneson, CPA, MBA
So, your startup has entered into a convertible note agreement. Your investors are interested, and you got the money in the door! Congratulations! Now what… and why did your accountant’s face just go pale?
The accounting for convertible debts is a very technical endeavor due to the extent of relevant accounting standards to consider and the significant judgments involved.
What Is a Convertible Note?
A convertible note is debt that can be settled in exchange for the issuance of a company’s shares of stock. Companies, particularly start up, early-stage technology and life science companies, issue convertible notes rather than raising money through the issuance of stock largely due to the fact that it is usually easier. There are more legal documents to issue stock, and early-stage stock investors are generally looking for preferential terms and rights that take time and cost to negotiate. Additionally, issuing stock has an impact on current investors (i.e., founders, venture capital funds), which brings consideration of enterprise value and dilution in determining the price of the stock to be sold. As such, a great way to “bridge” the gap is the issuance of convertible notes to investors so you can iron out the details of issuing stock later on, which is why these are often called “bridge loans.”
To incentivize investors to accept these notes, terms that provide sweeteners often show up in the agreements, including (but not limited to) a guaranteed conversion price set equal to or below the fair market value of the company’s stock on the date the note is issued; the ability to settle the convertible note in exchange for stock issued in a future round of equity financing (i.e., Series A Preferred Stock, etc.) or IPO at a discounted price ranging from 10% to 30% of the price of stock sold to investors in that round; and/or the ability to convert into the company’s stock at a stated valuation cap.
Why Are They So Hard To Account for?
Unfortunately, convertible notes bring with them a slew of accounting considerations. Foremost among them is whether those “sweeteners” constitute “embedded features.” Embedded features include conversion rights, redemption rights – sometimes considered put or call features – and beneficial rights that are written in the agreements. They may require a portion of the proceeds to be allocated and presented separately on the company’s balance sheet. Multiple accounting standards must be considered, including:
- ASC 815, Derivatives and Hedging. If an embedded feature meets the definition of a derivative, the feature must be bifurcated and valued at fair value upon issuance and at each subsequent reporting period.
- ASC 405-50, Debt Extinguishments and Modifications. Changing the terms of convertible notes requires additional consideration if a change in a conversion feature is substantial and relevant to the 10% cash flow test. Additionally, the ultimate settlement of debt into shares may constitute a debt extinguishment.
- ASC 825, Fair Value Option. Most likely, you have accounted for debt issued at the value of proceeds received, less issuance costs. However, a “hybrid instrument,” as convertible notes with embedded features are considered, may be measured at fair value with changes reported in earnings. There are exceptions, such as notes requiring bifurcation of a cash conversion or beneficial conversion feature – see ASU 2020-06
Common “bifurcations” are:
- A liability attributable to a warrant issued in tandem with the notes;
- A derivative liability representing the substantial discount; and
- A beneficial conversion feature recorded to equity.
The bifurcated values are recognized with an offsetting entry to debt issuance costs which is amortized through interest expense until the original note returns to its original value. Any liabilities recorded at fair value should be revalued at each measurement period.
Good News – It Will Get a Bit Easier
In August 2020, the FASB issued ASU 2020-06, which simplifies the accounting for certain financial instruments with characteristics of liabilities and equity, including convertible notes. The guidance primarily simplifies the accounting for convertible notes by no longer requiring the separation of an embedded conversion feature to equity, which is done when allocating the interest cost paid with respect to a cash conversion feature and the recording of the intrinsic value of a beneficial conversion feature.
The consequence of this is (1) it removes the need to assess for such features, and (2) it provides the ability to elect the fair value option for notes that would have been previously precluded from doing so due to the existence of these features, which provides for a more streamlined analysis of convertible notes.
For public business entities that meet the definition of an SEC filer, excluding entities eligible to be smaller reporting companies as defined by the SEC, the standard takes effect for fiscal years beginning after Dec. 15, 2021, including interim periods within those fiscal years. For all other entities, the standard will take effect for fiscal years beginning after Dec. 15, 2023, including interim periods within those fiscal years. Early adoption is permitted, but not sooner than January 1, 2021.
What Should You Do When You Have a Convertible Note?
Take a deep breath – there is a way to approach these notes.
Step 1: Fully understand the economics and mechanics of the notes. Were there any other instruments issued (i.e., warrants to purchase stock) that are required to be accounted for as a separate freestanding instrument? What are all the different ways the note can be settled and how does each scenario play out?
Step 2: Assess the accounting. Evaluate if there are different embedded features and whether they are conversion or redemption features. Can you adopt ASU 2020-06? Is it beneficial to elect the fair value method?
Step 3: Find a valuation specialist. You will need to consider what the short-term and long-term strategies are for these instruments. When are you likely to issue new shares? What is the most probable scenario to occur and which is the most beneficial to the investor? Then, you and the valuation specialist will determine what is the best way to model the various scenarios. Monte Carlo? Lattice? Binomial?
Step 4: Reassess every reporting period. Until the convertible note is settled, circumstances will continue to change, and it is important to ensure that you reassess your assumptions with each major change and each reporting period for impact to the value of the instruments.