AND KEVIN GAWRON

Estimated reading time: 6 minutes

Venture debt facilities often include fees and other equity-like components in the form of warrants. While these packages are generally negotiated with all components considered part of a debt-like package, U.S. Generally Accepted Accounting Principles (GAAP) requires a determination as to whether the components of the venture debt investment will need to be accounted for separately or as a combined instrument.

The question naturally arises:

Most venture debt packages have a variety of unique, negotiated terms specific to Company performance, etc. How can we tell what necessitates bifurcation of accounting treatment, and what will factor into the valuation of a pure debt investment?

One key factor in the assessment of treating an investment as a combined facility versus accounting for individual parts lies in the ability to trade its component pieces separately. To paint a better picture of what this means, let’s walk through an example of a detachable derivative component.

Example: Detachable Derivative Component

Firm A provides a $100 million term loan to Company B, which pays 10 percent annual interest for four years. In addition to the term loan, Firm A receives 10,000 common warrants in Company B, which are earned upon the initial financing and are reflected on Company B’s cap table.

In this case, Firm A received value from two separate components of the agreement:

• A term loan with related interest and return-of-principal economics, and
• Equity participation via the “free” warrants.

Firm A will need to assess this debt investment for financial reporting to determine if the warrants received have separable value and would classify as a freestanding financial instrument.

The ASC Master Glossary offers the following test to determine whether or not an instrument is freestanding:

“Freestanding financial instrument: A financial instrument that meets either of the following conditions:

1. It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
2. It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.”

For the subject investment, the second criteria would be triggered. Per the credit agreement, the warrants, which are owned upon issuance of the debt, are not dependent on the continued existence of the term loan facility and are detachable and can be separately monetized or sold by Firm A. Accordingly, Firm A would assess that the warrants are a freestanding financial instrument, despite being negotiated alongside the term loan, and would account for them at issuance as a component of the term loan as an original issue discount (OID). Effectively, the $100.0 million investment cost would need to be allocated to each debt and equity component.

In the “Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies,” Section 4.11, the guidance specifies the required treatment of a fund’s investment in a company:

“When estimating the fair value of the fund’s position in a given portfolio company, the concept of “economic best interest” is relevant to the determination of the nature of the assumed transaction and what grouping of assets may be appropriate. Therefore, the task force believes that it is appropriate to consider the unit of account for investments reported under FASB ASC 946 to be the individual instruments to the extent that is how market participants would transact, or the entire position in each type of instrument in a given portfolio company held by the fund (e.g., the entire senior debt position, the entire mezzanine debt position, the entire senior equity position, the entire warrant position, and so on) to the extent that is how market participants would transact.”

Section 4.15 of the “Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies” further clarifies the allocation of value between the individual components:

“When the assumed transaction is based on value being maximized through a transaction in the investment company’s entire interest in the portfolio company, then the investment company’s Schedule of Investments will generally present the aggregate fair value of the investment in each portfolio company along with each class of debt and equity owned in that portfolio company at its allocated value. One reasonable basis for allocating value amongst the instruments could be to estimate the fair value of each instrument independently, considering the assumptions that market participants would use in pricing each instrument, and then to allocate the aggregate fair value considering either the relative fair value of all the instruments (e.g., the fair value of equity or warrants vs. fair value of debt), or the residual fair value for one of the instruments after subtracting the fair value of the other instruments (e.g., the residual fair value of debt after subtracting the fair value of equity or warrants, or vice versa).”

Because Firm A’s ownership of the warrants is independent of its term loan facility, it will account for each piece separately. Firm A will attribute the value of the combined facility at investment and in following reporting periods, between the term loan component and the warrants. At investment, the warrants will likely be valued as a part of a broader company valuation, using a traditional valuation approach such as:

• A DCF assessment on projected future cash flows,
• A market approach, or
• Value indications stemming from a recent round of financing or a weighted average of combined approaches.

The determined total equity value will then be allocated to each equity class, including the warrants, using standard approaches, including:

• An option pricing model,
• A fully-diluted method, or
• A combination of the two.

We will assume we arrived at a total warrant value of $4.0 million received by Firm A for this discussion.

As outlined above, after attributing an initial $4.0 million value to the warrants, the Company will treat the warrant value as a component of the term loan’s OID, and assess the at-issuance, debt-only value of the term loan remaining after accounting for the OID, or $96.0 million in this case. Based on this value, and the contractual future cash flows, Firm A will calibrate the implied yield to maturity at investment for the debt only portion of 12 percent. Effectively, if the warrants were not included, Firm A or a market participant would require a higher yield, i.e., the aforementioned calibrated debt-only yield of 12 percent, versus the stated coupon on the debt instrument of 10 percent in a market transaction.

In future reporting periods, Firm A will continue to separately value the warrants and the term loan based on changes at the Company and in comparable debt markets. The value of the warrants will have to be assessed based on changes to the entity level and equity value due to milestone and fundamental performance changes, changes in comparable market metrics, changes to the capital structure (e.g., changes to debt and cash), or the Company’s progress towards an exit event, which may affect the equity value allocation method utilized.

The value of the term loan, via changes in the calibrated yield, will be assessed for any loan amendments, updates at the Company, which may either increase or decrease the riskiness of the debt facility and changes in market lending rates, specifically centered on changes to venture debt capital and related rates of return and overall performance of the venture capital markets.

Conclusion

Clearly, there is a lot to discuss regarding both the bifurcation of investments between individual components and the valuation consideration for individual components, both at investment and in subsequent reporting periods. At its core, however, this process is important for meeting technical accounting regulations and capturing the nature of venture debt investments.

It may seem that a venture debt facility with a few supporting warrants seems immaterial or simply part of the debt instrument. But, the value realized from a small warrant position on a future liquidity event may provide a material uplift to the overall economics of the original combined position.

In practice, VRC sees many more instances of the warrants being realized for material value versus expiring worthless, often after the separable debt instrument has been repaid.

VRC’s experience working with clients to value their venture debt investments combines our long history valuing a range of credit facilities with experience valuing equity securities in venture and private equity-backed companies with complex capital structures. If you have a complex investment and are unsure how to account for and value component pieces, we are here to help.

Sources:
pwc Viewpoint 8.3 Accounting for freestanding instruments issued together, Publication date: 31 Oct 2020
pwc Viewpoint 5.3 Determine whether an instrument is freestanding or embedded