Navigating Convertible Instruments for Business Fundraising

Thursday, February 29, 2024

Navigating Convertible Instruments for Business Fundraising

Adding complex features to your convertible instruments can lead to unexpected accounting and valuation challenges.

Why choose Convertible Instruments for fundraising?

Opting for convertible instruments is a popular choice for startups looking to raise funds.
These instruments allow companies to secure funds for their operations and expansion plans, with risk and payoff terms that suit both the company and its investors.
Take convertible debt, for instance, offering businesses lower interest rates than traditional debt. In return, investors gain the option to convert their debt into equity, providing an opportunity to share in the potential upside.

Complex features and their implications

Convertible instruments can come with a variety of intricate features:

Common features can include:

Conversion Option
Redemption Option
Liquidation preference

Complex features can include:

Variable conversion ratio
Shares/cash settlement
Contingent conversion/redemption

Including certain features may result in unexpected accounting and valuation implications.

Navigating accounting for Convertible Instruments

Regarding accounting classification for convertible instruments, a “substance over form” approach is prescribed by the standards.

This means looking beyond the legal name (e.g. Series A preferred shares) and focusing on the instrument’s contractual rights and obligations.

"Fixed for fixed" test

The “fixed for fixed” test is a key consideration in assessing whether a derivative (e.g. conversion option) qualifies as equity. For equity classification, a fixed number of the issuer’s shares must be exchanged for a fixed amount of cash or financial asset. If the test is not met, the derivative will be classified as a liability instead.

Unpacking accounting and valuation for traditional Convertible Intruments

Traditional Convertible Bond

A traditional convertible bond has a fixed conversion ratio, allowing the bond’s principal to convert into shares at a predetermined conversion price.
The conversion option satisfies the “fixed for fixed” test and is classified as equity.

Accounting for the Traditional Convertible Bond

The traditional convertible bond is accounted for using “split accounting”. This means that it is treated as a compound instrument, comprising both a liability element and an equity element.
The bond component is classified as liability, while the conversion option is classified as equity.

Valuation Implications

Bond Component:
Assess its fair value on a standalone basis, excluding the conversion option. This is done by discounting the bond cashflows (interest and principal payments) using a fair market interest rate.
Conversion Option Component:
Determine its fair value as the residual amount after subtracting the fair value of the standalone bond from the total proceeds raised. It is important to note that, generally, no fair value remeasurement is required for both the liability and equity components after initial recognition.

Unpacking accounting and valuation for non-standard Convertible Instruments

Non-Standard Convertible Bond

Differing from traditional bonds, a non-standard convertible bond may include unique features.
In a real-life example, a client issued a convertible bond where the conversion price is set at 80% of the average of volume weighted average price (VWAP) for 3 consecutive market days preceding the conversion date.

Accounting for Non-Standard Convertible Bond

The non-standard convertible bond here is treated as a hybrid instrument, comprising both a host contract component and an embedded derivative component.
Both components are classified as liabilities and are commonly accounted for at “fair value through profit or loss” (FVTPL).
Unlike the traditional convertible bond, the conversion option here does not satisfy the “fixed for fixed” test, leading to its classification as a liability.

Valuation Implications

Fair Value Remeasurement:
Generally, fair value remeasurement of the hybrid instrument is required at the end of each financial reporting period.
Valuation Methods:
Depending on an instrument’s terms, intricate valuation models like the Cox-Ross Rubin Model or Monte Carlo Simulation Model may be used.
In this example, a Monte Carlo Simulation Model to simulate share price movements, helping to assess favourable conditions for the investor to exercise the conversion option.
The payoffs to the investor from various simulations are used to determine the fair value of the non-standard convertible bond.

How we can help

We recognise the challenges of running a business. Among our services, we provide specialised valuation of intricate financial instruments (including convertible instruments).

Benefits for Your Business:

Leverage our expertise and experience to navigate the complexities of financial instrument valuation.
Rest assured that our valuation services adhere to accounting standards.
Choose the right financial instruments and confidently raise funds while ensuring smooth day to-day operations.

For further insights or to discuss your specific financial scenario, connect with us today.

View the infographic here: