Accounting for Warrants & SARs

Thoughtware Alert Published: Dec 22, 2020
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Issuing stock warrants has become increasingly popular in employee stock ownership plan (ESOP) transactions. Warrants are a financial instrument that allow the holder to purchase stock of the issuer at a specified price during the warrant term. In a leveraged ESOP transaction, companies are generally unable to finance the transaction wholly with senior bank debt. In many cases the selling shareholders accept debt that’s subordinated to the senior lender(s). Attaching warrants to the subordinated debt provides the selling shareholders additional return commensurate with the risk of their investment.

The warrants are generally issued with a strike price (the price the holder must pay to exercise the warrant) equal to the initial ESOP share value. In general, companies wish to remain 100 percent ESOP companies; therefore, the warrants are structured so the holders receive the difference between the strike price and the fair value of the stock when the warrants are exercised. Warrants containing features that require the entity to repurchase either the warrant itself or the underlying shares are considered “puttable.” See further discussion below.

Warrants can complicate the accounting for the ESOP transaction, as the guidance related to warrants is complex. FASB Accounting Standards Codification (ASC) 470-20, Debt with Conversion and Other Options, contains the guidance for debt issued with warrants. ASC 470-20 requires proceeds from the sale of a debt instrument with stock purchase warrants (detachable call options) be allocated to the two elements based on the relative fair values of the debt instrument without the warrants and of the warrants themselves at the time of issuance. This usually results in the debt being recorded at a discount or, occasionally, a reduced premium. The discount (or premium) is accreted to interest expense over the term of the loan using the effective interest method so the debt, at its term, is recorded at its face value.

To determine the fair value of the warrant, the company should use an option pricing model such as the Black-Scholes model. This calculation is simplified as ESOPs have an annual valuation done to determine the stock’s fair value. This is generally one of the harder inputs into a Black-Sholes model for privately held entities to determine.

The company also must consider proper classification of the warrant on the balance sheet. To determine the warrant’s classification, one must look at ASC 480-10, Distinguishing Liabilities from Equity. Under this guidance, an entity shall classify as a liability any financial instrument, other than an outstanding share, that, at inception, has both of the following characteristics:

a. It embodies an obligation to repurchase the issuer’s equity shares or is indexed to such an obligation.

b. It requires or may require the issuer to settle the obligation by transferring assets.

Careful consideration of the terms of the warrant agreement must be made to determine the warrant’s classification on the balance sheet. Warrants issued in conjunction with an ESOP transaction often have put rights for the holder of the warrant, as there’s no intent for the warrant holder to own shares in the company. These put rights require the company to purchase the shares upon exercise of the warrants. Put rights would meet both criteria a and b above as it embodies an obligation to repurchase shares and requires the issuer to settle the obligation with cash to the holder. This would result in the warrants being recorded as a liability on the balance sheet rather than equity. The warrant liability would be remeasured at each reporting period with the change in value of the warrants recorded as financing income or expense each year.

If warrants don’t meet the ASC 480-10 requirements, as noted above, the warrants are recorded in additional paid in capital at their initial fair value. They aren’t remeasured at each reporting period.

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