SPAC Warrants: 8 Frequently Asked Questions
April 23, 2021
By Angela Veal
Special purpose acquisition companies (“SPACs”) have been around since the 1990s. Although SPACs’ financial statements are often viewed as straightforward by some, SPACs do issue certain complex financial instruments (e.g., warrants) that need to be properly evaluated. Specifically on the topic of warrants, the SEC issued a public statement on “Accounting and Reporting Considerations for Warrants Issued by SPACs” on April 12, 2021 (the “SEC statement”), revisiting the accounting for such warrants. This re-evaluation may result in the change of SPAC warrants’ classification from equity to liability on the financial statements and potentially impact hundreds of SPACs that are currently active in the marketplace. Interestingly, in April (which may or may not be related to this renewed focus on SPAC warrants), the number of new SPACs has been reduced to only a handful.
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”). Concurrently, the SPAC sponsor or its permitted transferees may also purchase Class A warrants for $1.50 per warrant (the “private placement warrants”). 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 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 anti-dilution 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 your 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 generally would not result in the contract failing the fixed-for-fixed criterion, but do require further analysis to ensure that is not the case.
In certain private placement warrants’ agreements, there are provisions where the settlement provisions change depending upon who is holding the award at settlement (i.e., the sponsor, a permitted transferee or a non-permitted transferee). In many cases, this variable to the private placement warrant has not been used as an input to the fair value of the fixed-for-fixed option, and would fail the fixed-for-fixed criterion. This would therefore preclude the warrant from being indexed to the common stock and result in 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. 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.
Warrants that end up changing their classification from equity to liability would need to be re-measured at fair value every quarter (subject to quarterly public company filing requirements), with changes in fair value reported in earnings. 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 (as opposed to being allocated based on relative fair value of the warrants and Class A shares if the warrants were classified as 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 (e.g., when the misstatement has the effect of increasing management’s compensation) in which misstatements below a certain threshold (e.g., 5%) could be considered material. If the misstatement is deemed to be material to previously-issued financial statements, 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.
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.
It is also important to note that the above requirements are dependent on where the SPAC is at in its lifecycle, i.e., a) if it is still at the stage of filing its initial registration statement, b) if an IPO has already taken place, c) where it is in terms of the business combination transaction (negotiation, entered into the agreement, filed Form S-4, etc.) or d) whether it has already de-SPACed.
What are the internal control considerations?
SPACs should reassess the impact on its 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. This includes a consideration of whether there are any control deficiencies and an evaluation of the severity of the control deficiencies (individually and in aggregate).
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 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., settlement provisions, call options, or qualifying cash tender events).
- Engage with your auditor, accounting, valuation, and tax advisors as soon as possible.
- Determine the specific filing deadlines if a restatement is 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).