SPAC Warrants: 8 Frequently Asked Questions
May 17, 2021
Special purpose acquisition companies (“SPACs”) have been around since the 1990s. Last year saw a resurgence of SPACs and it has been widely anticipated that this trend would continue for the rest of the year. Most recently, however, SPAC activities came to a slight halt amid some regulatory pressure. Specifically on the topic of SPAC warrants, the SEC issued a public statement relating to Accounting and Reporting Considerations for Warrants Issued by SPACs on April 12, 2021 (the “SEC statement”), revisiting the accounting for such warrants.
As a background, SPACs are “blank check companies” that raise capital through an initial public offering in order to finance a merger with a target company within 18 to 24 months of the IPO. The actual purchase of a target company is not technically considered an IPO. However, it’s an IPO when the SPAC is first formed and capital is raised from the public. When the actual merger takes place 18 to 24 months later, no capital is raised.
Although SPACs’ financial statements are often viewed as straightforward by some, SPACs also issue certain complex financial instruments (e.g., warrants) that need to be properly evaluated. As highlighted in the SEC statement, this re-evaluation may result in the change of SPAC warrants’ classification from equity to liability on the financial statements. A restatement of financial statements may also be warranted if the misstatement is material. This potentially impacts hundreds of SPACs that are currently active in the marketplace.
There is a broad array of implications to consider (e.g., valuation) other than just accounting and reporting. Due to the tight SEC filing deadline, SPACs are encouraged to reach out to their advisors and auditors as soon as possible. Even if a change in classification in warrants or restatement may not ultimately be required after conducting an analysis, it is considered a best practice to formalize accounting positions relating to warrants and other issued financial instruments as an SEC filer.
SPACs that have not undergone IPOs yet are also encouraged to review their draft warrant agreements with their advisors to ensure that they are comfortable with the accounting positions to be taken. They should also consider running their preliminary conclusions by the SEC.
Below is a summary of frequently-asked questions (“FAQs”) on a spectrum of topics together with some high-level interpretations. It is essential to consult with advisors for discussions based on specific facts and circumstances.
What are SPAC warrants?
The most common SPAC warrants are either public warrants or private placement warrants. During an IPO, a SPAC will typically issue units to investors at $10 per unit. Each unit consists of a) one common share (“Class A share”) and b) one warrant or a fraction of such warrant to purchase an additional common share at an exercise price of $11.50 (the “public warrants” or “Class A warrants”). The public warrants typically cannot be exercised until a business combination event or at least 12 months after the SPAC’s IPO.
Through a private placement, the SPAC sponsor or its permitted transferees may concurrently purchase the warrants at a price of $1.50 per warrant (the “private placement warrants”). The private placement warrants are similar to the public warrants, but certain provisions may depend on who the holder is. For example, the protective provision preventing the SPAC from redeeming these warrants would fall away if the sponsor transfers the warrants to third parties.
SPACs may also issue other types of instruments similar to warrants, such as contingent forward purchase commitments to issue Class A shares at a fixed price, which are then settled right before a de-SPAC transaction. For the remainder of this discussion, we will focus mainly on public warrants and private placement warrants (collectively, the “SPAC warrants” or “warrants”).
What are the key terms of SPAC warrants?
The specific terms of SPAC warrants may vary; however, certain features are common with a few noted differences between public warrants and private placement warrants:
- Exercise contingencies. These may include contingencies whereby a merger would need to be completed by the SPAC or a forced early exercise (the latter applicable to public warrants).
- Settlement provisions: As highlighted on the SEC statement, there are certain provisions that result in an adjustment to settlement amounts (e.g., holder characteristics, down round adjustment provisions or standard down-round adjustment provisions)
- Tender offer provisions: As highlighted on the SEC statement, if a qualifying cash tender offer is made to and accepted by a majority of the holders of the outstanding common shares, all warrant holders would be entitled to receive cash for their warrants, but not all common shareholders would receive cash.
- Timing: They may be exercised either before or after a merger.
- Cash and/or cashless exercise: Private placement warrants may have both cash and cashless exercise whereas public warrants typically consist of only a cash exercise.
- Redemption provisions: Private placement warrants held by the SPAC sponsor may not have redemption provisions like public warrants that will be redeemed if the trading stock price exceeds a certain threshold.
What are the accounting implications?
Warrants are considered contracts that are settled in the SPACs’ own stock, and therefore need to be evaluated whether they should be classified as equity, an asset or a liability. Historically, many SPACs have classified warrants as equity on their balance sheets. The SPAC would first evaluate if the warrants are liabilities under ASC 480. If the warrants are not liabilities under ASC 480, they are then evaluated under ASC 815-40 to determine if they are equity. This evaluation can be very complex and may involve further discussion with an accounting advisor. There are two main nuances to be considered:
- Failure to meet the conditions under ASC 815-40-15
The warrants are classified as equity if they meet both conditions, namely a) they are indexed to the common stock (the “indexation condition”) and b) they meet the criteria for equity classification.
There are two steps to the indexation condition of which the second step is commonly known as the “settlement criterion” or “fixed-for-fixed criterion.” If there are variables that impact the settlement amount (e.g., standard anti-dilution adjustments, down-round adjustment provisions, or adjustments depending on the holder characteristic), the SPAC would need to evaluate if they meet the fixed-for-fixed criterion.
Standard anti-dilution provisions adjustments do impact the exercise price or number of shares issued. However, if the SPAC can determine that the monetary amount received by the warrant holder remains the same, they can conclude that the fixed-for-fixed criterion continues to be met.
The down-round adjustment provision is a feature that reduces the strike price of the warrant when a) the SPAC issues common shares for an amount less than the current strike price of the warrant, or b) the SPAC issues another equity-linked instrument with a strike price lower than the current strike price of the warrant. Down-round provisions may not result in the contract failing the fixed-for-fixed criterion, but do require further analysis to ensure that is not the case especially if this pertains to an “imperfect” down-round adjustment provision.
In certain private placement warrants’ agreements, there are provisions where the settlement provisions change depending upon who is holding the award at settlement. For example, the provision would say something to this extent: “The characteristics of the warrants would stay the same as long as they are held by the sponsor and permitted transferees.” In many cases, since the holder of the instrument is not an input into the pricing of a fixed-for-fixed option on equity shares, such a provision would preclude the warrants from being indexed to the SPAC’s common stock and the warrants should be end up with a liability classification.
- Failure to consider the net cash settlement provisions guidance under ASC 815-40-25-7 and 25-8
The guidance states that contracts with provisions requiring net cash settlement or where the occurrence of an event requiring the net cash settlement is not within the SPACs’ control cannot be accounted for as equity, unless the holders of the underlying shares would also receive cash.
Common provisions seen on warrant agreements would include tender or exchange offer provisions allowing cash settlements at the option of the holders.
For example, in certain qualifying cash tenders from third parties (e.g., when the value of the SPAC’s share price rises above a threshold level for a specified number of days), all warrant holders would receive cash but not all holders of the underlying shares of Class A shares would be entitled to cash. Even though the tender offers made may be at an amount below the redemption value and therefore the holders will likely exercise the warrants and get equity (and not cash), this guidance should still be considered for now. Therefore, the warrants would be precluded from being classified as equity.
The following are some key changes that need to be considered if warrants end up changing their classification from equity to liability:
- The warrants need to be re-measured at fair value every quarter-end and year-end (subject to both quarterly and annual public company filing requirements). This is in addition to the requirement to fair value warrants and recognized as such at their issuance date, which is always required whether they are classified as equity or liability.
- The SPAC would then recognize any changes in the fair value of the warrants from the prior period (as a “change in fair value of warrants”) in the SPAC’s operating results for the current period.
- If the warrants are classified as liability, the net proceeds from issuance of Class A shares and warrants (if issued as a single unit) would first be allocated to the warrants at an amount that equals the warrants’ issuance-date fair value, with the remaining net proceeds allocated to the Class A shares. If the warrants are classified as equity, the net proceeds are being allocated based on relative fair values of the warrants and Class A shares.
- Issuance costs for warrants that are classified as liabilities should be expensed immediately, whereas issuance costs for warrants that are classified in equity are generally be recorded as a reduction in equity.
- SPACs that have incorrectly classified the warrants as equity may be required to restate their financial statements if the impact is deemed material.
What is the impact on valuation?
If the warrants are classified as liabilities, a SPAC would need to update the valuation every quarter, instead of just at the initial issuance of the warrants when the SPAC is formed. The SPAC would also need to recalculate the value of the warrants for the Form 10-Ks and Form 10-Qs before and after the SPAC’s IPO.
For private placement warrants, the Black-Scholes pricing model is often used and can include inputs such as share price, strike price, estimated volatility, time-to-merger, time from assumed merger date until warrant expiration, risk-free rate and probability of a successful merger. To estimate volatility for periods prior to the consummation of a transaction, the post-transaction volatility may need to be based on the volatilities for other SPACs in the same industry that have completed a transaction or the implied volatility of other comparable SPAC warrants.
For public warrants that have more complex terms (e.g., a call or redemption feature based on the value of the shares over a specified period of time), the valuation model may be more complex, for example, with the use of a Monte Carlo simulation and multiplying this value with the probability of successful merger.
When would a restatement be required and what are the related SEC reporting requirements?
A SPAC would first need to evaluate if a misstatement is material. Evaluation of materiality requires a registrant and its auditor to consider all the relevant circumstances, as there could be certain circumstances even if the misstatements are below a certain threshold (e.g., 5% of earnings per share). If the misstatement has the effect of switching a net loss to net income position, or the effect of increasing management’s compensation, the misstatement may be considered material.
If the misstatement is deemed to be material to previously-issued financial statements and a “Big R restatement” is required, the SPAC would then need to file a restatement of previously-issued financial statements (most recent Form 10-K and Form 10-Qs filed subsequent to the most recent Form 10-K) and a Form 8-K (Item 4.02). The filings should also include restated footnote disclosures, including the required disclosures relating to ASC 250, Accounting Changes and Error Corrections as well as revised Management’s Discussion and Analysis.
Interestingly, quite a few SPACs have opted for a “Super 10-K” filing whereby they will restate the financials within this filing itself, instead of filing individual restated 10-Ks and 10-Qs.
Form 8-K is due within four business days after a SPAC concludes that a restatement is necessary. The SPAC should also contact the securities exchange once the decision is made but before the public announcement. For the Form 10-Ks and Form 10-Qs, the deadline can be extended if the SPAC complies with Rule 12b-25 of the Securities Exchange Act of 1934.
What are the internal control considerations?
SPACs should reassess the impact on their internal control over financial reporting (“ICFR”) on whether prior disclosure on management’s evaluation of ICFRs and disclosure controls and procedures need to be revised in the amended filings. Specifically, the internal control deficiencies should be evaluated both individually and in aggregate, together with their severity, in order to determine if management’s assessment on the effectiveness of the ICFR needs to be revised on the amended filings.
SPACs should also evaluate the strength of their internal control environment by performing a thorough risk assessment. Strong controls for SPACs may include the formation of a Disclosure Committee to discuss critical items such as the accounting position for warrants and other complex financial instruments.
What are the tax implications of SPAC warrants?
The tax treatment of warrants depends on whether the warrant is issued with equity or in the nature of compensatory warrants. For those warrants that are not considered compensatory, the investment warrant rules generally apply.
As investment warrants, they are typically considered to be part of a single unit consisting of a Class A share and a warrant. When the shareholder exercises the warrant, they pay the strike price indicated in the warrant for the share.
The shareholder’s basis in the share acquired through the exercise of the warrant is the cost originally allocated to the warrant at issuance and the amount paid upon exercise. The classification of warrants as equity versus liability might therefore result in an adjustment in the cost allocated to the warrant as discussed previously, which therefore results in a change in the shareholder’s basis in the acquired shares.
What are the immediate next steps to take?
- Review the terms of the warrant agreements for provisions that are potential nuances (e.g., down-round adjustment provisions, settlement provisions, call options, tender/exchange offers).
- Engage with your auditor, accounting, valuation, and tax advisors as soon as possible.
- Determine the specific filing deadlines assuming the scenario where a restatement were to be warranted (e.g., four business days for Form 8-K).
- Determine if the warrants should be classified as liabilities instead of equity, and confirm with your auditor.
- If the warrant is required to be classified as a liability, engage the valuation specialist to determine the appropriate valuation model and determine the fair value of the warrants at each reporting period.
- Determine if the misstatement is considered material both quantitatively and qualitatively to the previously-issued financial statements.
- If the misstatement is deemed material, make the required filings with SEC on a timely basis or where allowed, apply for an extension.
- If applicable, consider if the terms of the warrant agreements can be amended on a going-forward basis (e.g., for SPACs who have yet to finalize the warrant agreements).
OUR CURRENT ISSUE: Q2 2021