Analysis of SEC's Focus Points on SPAC Warrant Accounting

The following is a contributed article by Matt Smith and Petar Tomov, who areOpportune LLPdirectors in the Financial Instruments Group. The views expressed are those of the authors.

Since the U.S. Securities and Exchange Commission (SEC) issued itsstatementin early April regarding the accounting for warrants issued by special purpose acquisition companies (SPACs), many companies have been struggling to interpret its implications. This is not without reason. In many SPAC warrant agreements, the section on "Substitution of Securities upon Reorganization" contains a sentence that spans three-quarters of a page, and the related accounting guidance is equally daunting. This has led many to realize that there is a problem, but they are unsure of what exactly the problem is.

Overview of SPAC Warrants

SPACs (i.e., blank check companies) typically issue at least two types of warrants during their initial public offering (IPO) process:

• Private placement warrants: usually sold to sponsors to fund startup costs;
• Public warrants: usually issued to third-party investors alongside shares during the IPO to enhance the potential financial returns for investors.

The typical setup is that a SPAC issues units to third-party investors at a price of $10.00 per unit. Each unit typically contains the following two items:

• One share of Class A common stock ("Class A Share");
• A fraction of a warrant (usually 1/2, 1/3, 1/4, or 1/5) to purchase one Class A Share at an exercise price of $11.50 ("Public Warrant").

Public Warrants typically have a five-year term from the closing of the acquisition and contain a redemption provision: if the Class A Shares trade above a specified level (e.g., $18.00) for at least 20 of 30 consecutive trading days, the company can redeem the Public Warrants. The redemption price is typically set at a nominal amount, effectively forcing holders to exercise their warrants when the company issues a redemption notice.

SPAC sponsors typically purchase warrants ("Private Placement Warrants") to buy Class A Shares at an exercise price of $11.50 per share. These Private Placement Warrants are typically purchased at a price of approximately $1.50 each. Their terms are largely similar to the Public Warrants, but with the following differences:

• Private Placement Warrants include cash and cashless exercise, while Public Warrants can only be exercised for cash except in certain redemption scenarios;
• If the Private Placement Warrants are held by the SPAC sponsor or its permitted transferees, they do not include a redemption (forced exercise) provision.

Accounting Classification

Warrants to purchase publicly traded shares generally meet the definition of a derivative. However, the FASB accounting standard on derivatives and hedgingASC 815-10-15-74provides a scope exception from derivative accounting for contracts issued or held by a reporting entity that meet both of the following conditions:

• Indexed to its own stock;
• Classified in shareholders' equity on the balance sheet.

If a warrant agreement meets this scope exception, it is recognized in equity at initial recognition and no further accounting is required. However, if the warrant agreement does not meet the exception, it must be measured at fair value at each reporting period, with changes in fair value recognized in earnings.

Many SPACs had previously concluded that their warrants met the scope exception provided in ASC 815-10-15-74; however, the SEC's recent statement indicates that this conclusion may not have been appropriate. This means that many SPACs inappropriately applied equity classification, and therefore their historical financial statements contained errors, as they should have recognized the warrants as derivative liabilities at each reporting period and recognized changes in fair value in earnings.

Issue One: Indexation

To classify warrants as equity, the warrants must be considered "indexed" to the entity's own stock, and companies need to apply a two-step approach: (1) evaluate any contingent exercise provisions; (2) evaluate the settlement provisions. The SEC's focus is specifically on the settlement provisions of SPAC warrants.

The settlement provisions of the instrument must be evaluated to determine whether the instrument is indexed to the reporting entity's own stock. This guidance is often referred to as the "fixed-for-fixed" rule, which states that if the settlement amount of a warrant equals the difference between the fair value of a fixed number of shares and a fixed monetary amount, the warrant is considered indexed to the entity's own stock. For example, a warrant that gives the counterparty the right to purchase a fixed number of shares at a fixed price. There is an exception to this "fixed-for-fixed" rule that allows an instrument to be considered indexed to the reporting entity's own stock even if the settlement amount is adjustable, provided these adjustments are based on standard inputs used to determine the value of a "fixed-for-fixed" stock option or forward contract.

As noted above, if Private Placement Warrants are held by the SPAC sponsor or its permitted transferees, they are generally not redeemable. The SEC's statement indicates that this provision precludes equity classification for Private Placement Warrants because the instrument holder is not an input to the pricing of a "fixed-for-fixed" stock option.

Issue Two: Tender Offer Provisions

To meet the second part of the derivative scope exception, the instrument must be classified in shareholders' equity on the balance sheet. This depends on whether the entity controls the ability to settle the contract in shares. SPAC warrants typically contain a provision that allows holders to receive cash in the event of a tender or exchange offer involving the common stock underlying the warrants.

According to ASC 815-40-55 paragraph 2, events that result in a change in control of the entity are not within the entity's control, and therefore, if a contract requires net cash settlement upon a change in control, the contract generally must be classified as an asset or liability. However, the next paragraph provides an exception: if net cash settlement is triggered only when holders of the underlying shares also receive cash, equity classification is not precluded.

Many practitioners have historically believed that the above exception applied because warrant holders and underlying share holders receive similar consideration on a pro rata basis, regardless of the type of security. However, the SEC concluded that the exception can only be applied when the event triggering cash settlement also results in a change in control of the entity. If the entity has two classes of common stock, or if the entity has other classes of securities entitled to vote, a change in control may not occur, and therefore the exception does not apply, failing the requirement to be classified in shareholders' equity on the balance sheet.

Next Steps

Although the SEC identified two specific issues in its statement, they reiterated that evaluating the accounting for warrants issued by SPACs requires careful consideration of the specific facts and circumstances of each entity and each contract. Companies have been working with valuation and financial reporting advisors to assess the impact on their historical financial statements and determine whether restatements are necessary.

From a valuation perspective, the simplest approach is to use a closed-form solution such as the Black-Scholes model. However, due to the redemption provisions prevalent in public SPAC warrants, this approach is often insufficient to determine their fair value. Therefore, more complex path-dependent models, such as Monte Carlo simulation, are often required.

This more complex valuation process makes it particularly important for financial executives to work with firms that can appropriately assist in evaluating the classification of SPAC warrants.