Embedded Derivatives with Tranches – The Promise of More Money

So Your Investor Promised You More Money in the Future! Great, but…

Congratulations! You’ve received some funding from investors and, as an added bonus, they’ve promised, in writing nonetheless, that you will receive more of their money if you achieve certain operational goals. Ok, that part is not so easy, but you have faith in your colleagues at work. All you must do is keep good track of the money and have good financial and operational controls.

Unfortunately, you have some accounting homework to do too. Those forthcoming tranches, they are known as forward contracts and they may contain the dreaded “D” word – DERIVATIVES! This homework assignment can be completed if you attack it in an orderly manner. ASC 815-15 lays out the steps you should follow. I’ll try to lay out some simple guidelines but, for the sake of the audit, please look to the standard; it’s like peeling an onion.

First, you’ll need to determine (a) whether these future tranches are freestanding financial instruments requiring their own accounting or (b) if there is a contractual feature that is embedded in the preferred shares. If either (a) or (b) occurs, the bifurcation guidance of ASC 815-15 should be followed.

ASC 480-10-20 defines a freestanding financial instrument as one that (1) is entered into separately and apart from any of the entity’s other financial instruments or equity transactions; or (2) is entered into in conjunction with some other transaction and is (a) legally detachable and (b) separately exercisable. If the instrument does not meet these conditions, then a feature is embedded in a transaction.

With respect to subsection (a) above, two instruments can be legally detachable if the instruments can be separated and transferred such that multiple parties can hold each instrument, i.e. each tranche. For this, one may need not only to refer to the closing documents but also consult with the securities attorney. Oftentimes, the Investors’ Rights Agreement may have numerous contractual hurdles for one party to sell its shares to another outside party. Further, the Agreement may define “significant holders” or some similar term whereby those investors lose certain rights if their holdings fall below a certain amount. Therefore, in fact, the shares may not be legally detachable.

If the shares are separately exercisable, meaning an investor can hold one tranche and invest in the next, then both (a) and (b) above are not satisfied and, therefore, the tranches are not freestanding.

Now you can go to your favorite ASC: ASC 815-15-25-1. It states that an embedded derivative is separated from the host contract and accounted as a derivative instrument if all the following criteria are met:

1. The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
2. The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
3. A separate instrument with the same terms as the embedded derivative would be a derivative instrument.

If you’re with a privately-held company, you’re in luck. The future right does not meet the definition of a derivative (it is not settleable because the underlying shares are not readily convertible to cash) and you, thankfully, flunk c. above. Therefore, the future tranche obligation cannot be bifurcated and should not receive separate accounting.

Thank God this is over; my head was about to explode.