A hybrid instrument is a contract that embodies both an embedded derivative and a host contract. A host contract is the instrument or contract that would be issued if a hybrid instrument did not contain an embedded component; it is the hybrid instrument without the embedded component.
When considering whether an embedded equity-linked component is clearly and closely related to its host instrument, a reporting entity should first determine whether the “economic nature” of the host is an equity host or a debt host. An embedded equity-linked component is generally considered clearly and closely related to an equity host; it is not considered clearly and closely related to a debt host. To determine the nature of the host contract, the reporting entity should consider all stated and implied substantive terms and features of the hybrid instrument (inclusive of the embedded component).
Sometimes, the nature of the host contract is straightforward; a hybrid instrument that is legally a debt instrument has a debt host contract. However, determining whether a hybrid instrument that is legally an equity instrument (e.g., a preferred share) is a debt or equity host contract requires judgment. As discussed in
ASC 815-15-25-17A, all of the substantive contractual and implied terms of the preferred share, such as the existence of a redemption feature or conversion option, should be considered when determining the nature of the host instrument as debt or equity.
ASC 815-15-25-17A
For a hybrid financial instrument issued in the form of a share, an entity shall determine the nature of the host contract by considering all stated and implied substantive terms and features of the hybrid financial instrument, weighing each term and feature on the basis of the relevant facts and circumstances. That is, in determining the nature of the host contract, an entity shall consider the economic characteristics and risks of the entire hybrid financial instrument including the embedded derivative feature that is being evaluated for potential bifurcation. In evaluating the stated and implied substantive terms and features, the existence or omission of any single term or feature does not necessarily determine the economic characteristics and risks of the host contract. Although an individual term or feature may weigh more heavily in the evaluation on the basis of the facts and circumstances, an entity should use judgment based on an evaluation of all of the relevant terms and features. For example, an entity shall not presume that the presence of a fixed-price, noncontingent redemption option held by the investor in a convertible preferred stock contract, in and of itself, determines whether the nature of the host contract is more akin to a debt instrument or more akin to an equity instrument. Rather, the nature of the host contract depends on the economic characteristics and risks of the entire hybrid financial instrument.
ASC 815-15-25-17C
When applying the guidance in paragraph 815-15-25-17A, an entity shall determine the nature of the host contract by considering all stated and implied substantive terms and features of the hybrid financial instrument, determining whether those terms and features are debt-like versus equity-like, and weighing those terms and features on the basis of the relevant facts and circumstances. That is, an entity shall consider not only whether the relevant terms and features are debt-like versus equity-like, but also the substance of those terms and features (that is, the relative strength of the debt-like or equity-like terms and features given the facts and circumstances). In assessing the substance of the relevant terms and features, each of the following may form part of the overall analysis and may inform an entity’s overall consideration of the relative importance (and, therefore, weight) of each term and feature among other terms and features:
- The characteristics of the relevant terms and features themselves (for example, contingent versus noncontingent, in-the-money versus out-of-the-money)
- The circumstances under which the hybrid financial instrument was issued or acquired (for example, issuer-specific characteristics, such as whether the issuer is thinly capitalized or profitable and well-capitalized)
- The potential outcomes of the hybrid financial instrument (for example, the instrument may be settled by the issuer issuing a fixed number of shares, the instrument may be settled by the issuer transferring a specified amount of cash, or the instrument may remain legal-form equity), as well as the likelihood of those potential outcomes. The assessment of the potential outcomes may be qualitative in nature.
Figure FG 5-3 shows some common attributes (i.e., it is not a comprehensive list) that should be analyzed to determine the nature of the host contract.
Figure FG 5-3
Analyzing the nature of the host contract
Attribute |
Indicates the instrument is debt-like |
Indicates the instrument is equity-like |
Cumulative or mandatory fixed dividends |
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Discretionary dividends based on earnings |
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Participation in the residual equity of the issuer |
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Preference in liquidation |
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Debt-like protective covenants |
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None of these factors alone is determinative of the nature of a host contract; the terms and conditions as a whole, as well as, potential outcomes should be evaluated and weighted based on the facts and circumstances. For example, a redemption feature that becomes exercisable based on the passage of time would carry more weight than a redemption feature that only becomes exercisable based on an event that is remote of occurring.
ASC 815-15-25-17D provides additional guidance on assessing each of these attributes.
Whether the host contract is a debt host or an equity host does not determine the instrument’s balance sheet classification. For example, a preferred stock contract that has a debt host for purposes of evaluating embedded components should not necessarily be classified as debt by the issuer.
Example FG 5-2, Example FG 5-3 and Example FG 5-4 illustrate the analysis used to determine whether the nature of a preferred stock host contract is more debt-like or equity-like.
EXAMPLE FG 5-2
Convertible, redeemable preferred equity issued by a thinly capitalized entity
FG Corp, an early stage software company, developed a software solution that is licensed to small and medium-sized enterprises. In its most recent fiscal year, FG Corp recorded sales of $6 million, a 200% increase over the prior year, and a net loss of $2 million. Management estimates that existing cash on hand is sufficient to fund FG Corp’s operations for an additional 3 months.
To date, FG Corp has raised $7 million of equity financing (common stock) and $4 million of debt financing (bank debt). FG Corp has not historically paid dividends and it does not expect to do so in the near to intermediate term.
To raise capital to finance its future operating needs, FG Corp issues Series A preferred stock with a $2 million stated value ($2.00 per share) to a single investor, Investor Co. All capital raised by FG Corp will be utilized to increase the size of its sales force and enhance its current software development capabilities.
The key terms of the Series A preferred stock are:
- 8% cumulative, fixed-rate dividends (increases the liquidation preference if not paid in cash)
- Convertible into common stock on a 1:1 basis anytime at the option of the holder
- Automatically converts into common stock upon an initial public offering or sale of the company
- Redeemable at the option of the holder after 5 years for cash equal to the stated value of the Series A preferred stock plus accrued and unpaid dividends
- Voting rights on all significant matters submitted for common stockholder vote on an as-converted basis
- Participates in common stock dividends on an as-converted basis
- No creditor rights
- No collateral requirements
The fair value of FG Corp’s common equity was $1.40 per share on the date the preferred stock was issued. FG Corp’s stock price is volatile and could change significantly based on future sales and profitability.
At the time the Series A preferred stock was issued, FG Corp reported an accumulated deficit of $7 million. Based on its current capitalization and stage of operations, there is significant uncertainty regarding FG Corp’s ability to settle the redemption feature in five years, if exercised because the preferred stock is in substance the residual equity in the company. Although FG Corp’s current financial position is tenuous, Investor Co expects the business to perform well over time and to exit its investment through conversion into FG Corp’s common equity (through a public offering).
Is the nature of the preferred stock host contract more debt-like or equity-like?
Analysis
When considering all relevant terms and features (i.e., the “whole instrument” approach), the host contract should be considered an equity host.
The existence of cumulative, fixed-rate dividends and a non-contingent redemption feature that is exercisable in five years may indicate the existence of a debt host. However, mitigating considerations exist, including the fact that the realization of these dividends may be tied to the redemption of the instrument, which may not occur, and if redemption is required, there is significant uncertainty as to FG Corp’s ability to fund those dividends because the preferred stock is effectively the residual equity in the company.
In contrast, the conversion feature would appear to be a strong indicator that the host contract is more akin to an equity host contract. At the time Investor Co acquired the Series A preferred stock, Investor Co understood that FG Corp might encounter going concern issues if an initial public offering or sale of the company did not occur, and that its economic return was therefore tied to a successful initial public offering or sale.
Other equity-like terms and features include the voting rights and common stock dividend participation rights. Because Investor Co has the ability to vote on all significant matters submitted for shareholder vote, the voting feature should be weighed more heavily in the host contract determination than if they were only permitted to vote on protective matters. The ability of Investor Co to participate in common stock dividends on an as-converted basis should not heavily influence the host contract determination, because FG Corp has not paid, and is not expected to pay dividends to common shareholders in the near term. The investor’s return of and on its capital is highly dependent upon the business performing successfully and an expected exit through the conversion feature.
Although the Series A preferred stock is redeemable at the option of Investor Co after five years, the instrument’s payoff profile is inconsistent with a fixed-income investment with the upside of a residual interest through the conversion feature. If the redemption feature is exercised, FG Corp may lack sufficient assets to redeem the instrument, or may be legally prohibited from doing so if that action would cause FG Corp to become insolvent. Given FG Corp’s current financial position and the uncertainty regarding its wherewithal to perform under this potential future obligation, the redemption feature should not be weighed heavily in the host contract determination. This suggests the Series A preferred stock is, in substance, a residual interest in FG Corp.
The host contract contains no creditor rights that would indicate that it is more akin to a debt host contract (e.g., rights to force FG Corp into bankruptcy or participate in a creditor committee to force the company to reorganize or liquidate). The substance of the liquidation preference is questionable and should not heavily influence the host contract determination, because Investor Co is unlikely to receive cash or assets equal to a stated liquidation should the company liquidate because it is effectively the residual equity in the company.
Investor Co appears to be taking residual equity risk, and its ability to achieve a meaningful economic return is dependent upon FG Corp’s successful performance and undertaking of an initial public offering or sale to a third party. As a result, the considerations described above indicate that the Series A preferred stock represents an in-substance residual interest in FG Corp and the host contract should be considered to be equity.
EXAMPLE FG 5-3
Convertible, redeemable preferred equity with creditor rights issued by a thinly capitalized entity
FG Corp, an early stage software company, developed a software solution that is licensed to small and medium-sized enterprises. In its most recent fiscal year, FG Corp recorded sales of $6 million, a 200% increase over the prior year, and a net loss of $2 million. Management estimates that existing cash on hand is sufficient to fund FG Corp’s operations for an additional 3 months.
To date, FG Corp has raised $7 million of equity financing (common stock) and $4 million of debt financing (bank debt). FG Corp has not historically paid dividends and it does not expect to do so in the near to intermediate term.
To raise capital to finance its future operating needs, FG Corp issued Series A preferred stock with a $2 million stated value ($2.00 per share) to a single investor, Investor Co. All capital raised by FG Corp will be utilized to increase the size of its sales force and enhance its current software development capabilities.
The key terms of the Series A preferred stock are:
- 8% cumulative, fixed-rate dividends (increases the liquidation preference if not paid in cash)
- Convertible into common stock on a 1:1 basis anytime at the option of the holder
- Automatically converts into common stock upon an initial public offering or sale of the company
- Redeemable at the option of the holder after 5 years for cash equal to the stated value of the Series A preferred stock plus accrued and unpaid dividends
- Voting rights on all significant matters submitted for common stockholder vote on an as-converted basis
- Participates in common stock dividends on an as-converted basis
- No collateral requirements
The fair value of FG Corp’s common equity was $1.40 per share on the date the preferred stock was issued. FG Corp’s stock price is volatile and could change significantly based on future sales and profitability. Public Corp, a well-capitalized public registrant with an investment-grade credit rating, owns a majority of FG Corp’s common equity.
At the time Investor Co acquired the Series A preferred stock, significant uncertainty existed regarding the likelihood of an initial public offering. To mitigate this risk, Investor Co requested that Public Corp guarantee FG Corp’s obligation to redeem the Series A preferred stock. If FG Corp is unable to perform upon exercise of the redemption feature, Public Corp is obligated to satisfy any part of FG Corp’s obligation that remains unfulfilled (i.e., Public Corp has guaranteed FG Corp’s written put option on its Series A preferred stock). If Public Corp fails to perform on its guarantee, Investor Co may pursue legal recourse against Public Corp and would have creditor rights against Public Corp if it failed to perform.
Is the nature of the preferred stock host contract more debt-like or equity-like?
Analysis
When considering all relevant substantive terms and features, the host contract should be considered a debt host.
With the exception of the stated dividends, expected outcome and the non-contingent fixed-rate redemption feature, other factors would be evaluated in a manner consistent with Example FG 5-2.
In this fact pattern, the mandatory conversion feature would be weighted less heavily given the uncertainty surrounding the likelihood of an initial public offering. This uncertainty is underscored by Investor Co’s request for Public Corp’s guarantee of the redemption feature, as it indicates that there is a higher probability that Investor Co will realize its investment through exercise of the redemption feature.
Although Investor Co may not receive the stated dividends on a current basis, it can eventually realize the value of the dividends in cash upon exercise of the redemption feature.
With respect to the redemption feature, although concerns exist regarding FG Corp’s obligation to perform if the instrument is redeemed, Public Corp’s guarantee of FG Corp’s obligation to perform upon redemption influences the substance of the Series A preferred stock’s liquidation preference. Furthermore, the presence of creditor rights should FG Corp and Public Corp fail to redeem the preferred shares upon exercise is a strong indicator of the presence of a debt host contract.
Considering the higher probability that Investor Co will exit its investment through exercise of the redemption feature, Public Corp’s guarantee of the redemption feature, the substance of the liquidation preference, and the significant risk associated with the conversion feature, the Series A preferred stock represents an in-substance fixed-income investment with residual “upside” and the host contract should be considered a debt host.
EXAMPLE FG 5-4
Convertible, redeemable preferred equity with a high likelihood of conversion
In order to satisfy increased demand for its products, Issuer Corp plans to finance the acquisition of new manufacturing equipment through the issuance of convertible preferred stock at a stated value of $2 per share. The terms of the preferred stock are as follows:
- Redeemable at stated value plus accumulated and unpaid dividends upon a vote of 66% of the holders of preferred stock. The preferred stock is held by a large number of unrelated investors, none of whom individually own more than 5% of the preferred stock issued. The investor group is diverse and includes short-term investors, long-term investors, and strategic investors.
- The purpose of the redemption feature is to provide the investor group with protective rights
- Convertible at the option of the holder after 5 years on a 1:1 basis into Issuer Corp’s common shares. Issuer Corp’s stock price on the issuance date is $1.80 per share.
- Voting rights on all significant matters submitted for common stockholder vote on an as-converted basis
- Participation in common stock dividends on an as-converted basis. Issuer Corp has historically paid dividends on its common stock and expects to continue to do so.
- No creditor rights
- No collateral requirements
Investors in Issuer Corp’s preferred stock expect to exit their investment through exercise of the embedded conversion option.
Is the nature of the preferred stock host contract more debt-like or equity-like?
Analysis
When considering all substantive relevant terms and features, the host contract should be considered an equity host.
The holder’s conversion feature is substantive and therefore should be ascribed weight in the host contract determination. In addition, the preferred stock entitles its holder to vote on all significant matters. As described in
ASC 815-15-25-17D(c), voting rights are generally viewed as an equity-like feature, and are given more weight in the host contract determination when the investor has the ability to vote on all significant matters (as opposed to being voting rights that are designed to be protective in nature). Finally, the preferred stock entitles its holder to participate in dividends on the same basis as the common stockholders, another equity-like feature. This feature would be weighted more heavily given that Issuer Corp has historically paid dividends and expects to do so for the foreseeable future.
Although a fixed price redemption feature exists and would be considered a debt-like characteristic, this feature is considered to be more protective in nature and requires 66% of the holders of the preferred stock to vote to exercise it. Given that the preferred stock is widely held by a diverse group of investors with different investment objectives, together with the fact that none of the preferred stockholders are related parties, there are constraints to exercising the redemption feature. As such, the fixed price redemption feature is considered more protective in nature and would be ascribed less weighting in the host contract determination.
Given the additional weight ascribed to the equity-like conversion feature relative to the debt-like redemption option, and the investors’ ability to vote on all significant matters and participate in dividends with the common stockholders, the host contract should be considered an equity host.