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7.6 Tranched preferred stock
Publication date: 31 Dec 2022
us Financing guide
A tranched preferred stock issuance is one in which preferred stock is issued with a simultaneous contractual commitment, which either (1) requires the issuer to issue additional series at a future date or upon occurrence of a specified milestone or (2) gives investors the option to require the issuer to issue additional series at a future date or upon occurrence of a specified milestone.
From the investor’s perspective, tranched financing defers a portion of the cash funding. Milestones align the commitment of funds to the issuer’s performance. From the issuer’s perspective, tranched preferred stock reduces fundraising efforts and funding risk if the milestones are achieved.
The issuer should determine whether the commitment to issue preferred stock in the future is a freestanding instrument or a component embedded in the initial issuance. The ASC Master Glossary provides a definition of a freestanding financial instrument.
Definition from ASC Master Glossary
Freestanding Financial Instrument: A financial instrument that meets either of the following conditions:
- It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
- It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.
Since the commitment to issue preferred stock is typically entered into in connection with the issuance of the first tranche of preferred stock, an issuer should consider the provisions in (b) above by answering the following questions.
- Are the first tranche of preferred stock and the commitment to issue shares legally detachable?
- Are the first tranche of preferred stock and the commitment to issue shares separately exercisable?
As discussed in FG 5.3, we believe separate exercisability is a strong indicator that a component is freestanding because a component must first be detached from its host instrument (i.e., the preferred stock) before it can be separately exercised. However, some issuers put more weight on whether the commitment to issue shares is legally detachable from the first tranche of preferred stock when determining whether it is freestanding or embedded. Generally, if the transaction documents do not specifically state that the commitment cannot be transferred separate from the preferred stock, the commitment is considered freestanding. See FG 5.3 for additional information on determining whether an instrument is freestanding or embedded.
An issuer’s accounting for the commitment to issue additional preferred stock may differ if it is a freestanding instrument versus embedded in the originally issued preferred stock.
7.6.1 Commitment to issue shares is a freestanding instrument–after adoption of ASU 2020-06
If a commitment to issue additional preferred stock is a freestanding instrument, the issuer should determine the appropriate classification of that freestanding commitment. The classification affects the methodology for allocating the proceeds received to the originally issued preferred stock and the commitment to issue additional preferred stock.
The commitment to issue additional preferred stock should first be evaluated to determine whether it is a liability within the scope of ASC 480. See FG 5.5 for information on ASC 480. If it is not within the scope of ASC 480, it should be evaluated using the model for freestanding equity-linked instruments discussed in FG 5.6.
If an issuer determines that a commitment to issue additional preferred stock should be classified as equity, the proceeds from the original issuance should be allocated to the originally issued preferred stock and the commitment to issue additional preferred stock using the relative fair value method. The commitment to issue additional preferred stock should not be subsequently remeasured if it is classified as equity.
When an issuer determines that a commitment to issue additional preferred stock meets the definition of a derivative, or determines that it does not meet the requirements for equity classification and does not meet the definition of a derivative, the proceeds from the original issuance should be first allocated to that commitment at fair value, with any remainder allocated to the originally issued preferred stock. The commitment to issue additional preferred stock should be subsequently recorded at fair value with changes in fair value recorded in the income statement. See FG 5.6 for further information.
The allocation of value to a commitment to issue additional preferred stock may create a discount from the redemption amount of the originally issued preferred stock, which may have to be amortized. See FG 7.4.3 for information on the subsequent measurement of preferred stock, including the amortization of a discount.
7.6.1A Commitment to issue shares is a freestanding instrument—before adoption of ASU 2020-06
If a commitment to issue additional preferred stock is a freestanding instrument, the issuer should determine the appropriate classification of that freestanding commitment. The classification affects the methodology for allocating the proceeds received to the originally issued preferred stock and the commitment to issue additional preferred stock.
The commitment to issue additional preferred stock should first be evaluated to determine whether it is a liability within the scope of ASC 480. See FG 5.5 for information on ASC 480. If it is not within the scope of ASC 480, it should be evaluated using the model for freestanding equity-linked instruments discussed in FG 5.6.
If an issuer determines that a commitment to issue additional preferred stock should be classified as equity, the proceeds from the original issuance should be allocated to the originally issued preferred stock and the commitment to issue additional preferred stock using the relative fair value method. The commitment to issue additional preferred stock should not be subsequently remeasured if it is classified as equity.
If an issuer determines that a commitment to issue additional preferred stock should be classified as a derivative, the proceeds from the original issuance should be first allocated to that commitment at fair value, with any remainder allocated to the originally issued preferred stock. The commitment to issue additional preferred stock should be subsequently recorded at fair value with changes in fair value recorded in the income statement.
If the commitment to issue additional preferred stock does not meet the requirements for equity classification and does not meet the definition of a derivative, the issuer should record the commitment as an asset or a liability and subsequently measure using appropriate US GAAP. See FG 5.6A for further information.
The allocation of value to a commitment to issue additional preferred stock may create a discount from the redemption amount of the originally issued preferred stock, which may have to be amortized. See FG 7.4.3 for information on the subsequent measurement of preferred stock, including the amortization of a discount.
7.6.2 Commitment to issue shares is an embedded component
If the commitment to issue additional preferred stock is an embedded component, it should be evaluated to determine whether it should be bifurcated from its host and separately accounted for as a derivative based on the guidance in ASC 815. See FG 5.4 for the model for analyzing embedded equity-linked components. If an embedded commitment to issue additional preferred stock should be separated and accounted for as a derivative, a discount from the redemption amount of the preferred stock will be created, which may have to be amortized. See FG 7.4.3 for information on the subsequent measurement of preferred stock, including the amortization of a discount.
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