Common complex financial instruments in the technology industry

Part 1: Warrants

In a nutshell

2020 has been a bizarre and unreal experience. However, despite this turbulence, the technology industry has shown incredible resilience while driving innovation. Other industries have suffered from the impacts of the coronavirus (COVID-19) pandemic but businesses in the technology sector were not as heavily impacted. This is why such businesses continues to attract significant capital. We are seeing healthy levels of deal and investment activities in the technology sector.

With increasing investment, there is an ever-evolving complexity in the financial instruments entered into. Common complex financial instruments that we see regularly include complex warrants and option agreements and complex convertible loan notes as well as other complex equity instruments. The complexity arises because these instruments could be classified as equity or debt or both and the valuation could be at transaction price or at fair value.
In this article, we focus on practical issues related to complex warrant agreements.

Background

Share warrants are instruments that give the holder a right, but no obligation, to purchase an entity’s shares at a specified price and date.
Entities typically issue warrants to raise capital and encourage investors to buy shares in their entity. They receive funds when they sell the warrants and again when shares are purchased using the warrant. Warrants are typically priced inexpensively compared to the underlying share, making them more appealing to investors, especially if it’s for an unproven company.

However, a warrant does not mean the actual ownership of the shares but rather the right to purchase the company shares at a particular price in the future. Warrants are therefore a type of derivative, which means that they rely on an underlying share for pricing.

This publication relates to warrant instruments issued without separate services provided. This is the most common type of warrant instruments issued in the technology industry.

Evelyn Partners view:

The classification and valuation of warrants is not straightforward and requires significant judgment.

As a result, this may have a significant effect on the entity’s reported results and financial position. Liability classification affects an entity’s gearing ratios and typically results in any payments being treated as interest and charged to earnings. This may also impact debt covenants. Equity classification avoids these impacts but may be perceived negatively by investors if it is seen as diluting their existing equity interests.

Understanding the classification process and its effects is therefore a critical issue for management and must be kept in mind when evaluating alternative financing options.
The fixed-for-fixed condition is relevant for derivatives, which is part of the definitions in IAS 32 or within the scope of section 12 of FRS 102. The flow chart below provides clarity on classification:

Practical implications to be aware of:

A single word may change the accounting of these financial instruments completely. Existence of other side agreements that directly impact the conditions relating to the warrants may also change the accounting of these financial instruments. As a result, the accounting treatment and subsequent valuation may differ significantly. Below are common implications.

Valuation considerations

There are two significant areas that management needs to consider:

Class of share - it is unlikely that the fair value for each class of share would be equal – for example, preference shares generally carry a higher value than ordinary shares. Assessing the fair value of the warrants would depend on which class of shares it converts into. Calculating the fair value may be complex, particularly in an unlisted environment.

Warrant complexity - the more the redemption scenarios, the greater the need for a complex statistical calculation. Non-complex warrants may be valued using a Black-Scholes model but complex versions may require sophisticated models such as Monte Carlo or Binomial models. The Monte Carlo or Binomial models are likely to require specialist advisers to assist with the valuation.

Evelyn Partners view

As warrant agreements occur less frequently in an entity, it is important to ensure the accounting and valuation are carried out appropriately. Without due care and use of specialist support, poor decision-making or unnecessary material errors may occur.

Tax considerations for issuer

Whether the warrant agreement is taxed under the derivative contracts legislation or as chargeable gains will be dependent on the nature of the underlying instrument and its accounting treatment. Tax advice should be obtained if a company is considering issuing warrants as the tax rules are complex.

If the warrant falls within the derivative contracts legislation, it is generally taxed in line with how it is recognised in the profit and loss account over the life of the warrant.

If the warrant falls within the chargeable gains legislation, for example where it is treated as an equity instrument, a tax charge on issuance could arise. The tax may be potentially recoverable on exercise if conditions are met.

Evelyn Partners view

As warrant agreements are taxed in line with their underlying nature and accounting treatment, the agreement should be reviewed before being issued to understand what tax rules may apply, what tax specific clauses should be included in the agreement and whether or not there are any valuations for tax that need to be undertaken.