Accounting for Convertible Instruments

A convertible instrument is a financial security that combines features of both debt and equity, starting as a security like a loan or preferred stock with a provision to be exchanged for the issuer’s common stock. This structure allows a company to raise capital at a lower interest rate compared to traditional debt. For an investor, it offers the potential to benefit from a company’s future growth.

If the stock price increases, the investor can convert the instrument into stock for a greater return. If the stock underperforms, they can hold the instrument to maturity and receive their principal, similar to a standard debt investment.

Common Types of Convertible Instruments

Convertible Bonds

Convertible bonds are corporate debt securities that can be converted into a predetermined number of the company’s common shares. They function like traditional bonds with a par value (face value), a coupon rate for annual interest, and a set maturity date for principal repayment if not converted.

The conversion feature is governed by a conversion ratio, which specifies the number of shares a bondholder receives. For example, a bond with a $1,000 par value and a ratio of 20 can be exchanged for 20 shares of common stock.

Convertible Preferred Stock

Convertible preferred stock is a class of stock with an option to convert into a fixed number of common shares. It holds a senior position to common stock, meaning preferred shareholders receive dividends first and have priority in payment during a liquidation, though they are still junior to debt holders.

A primary feature is its fixed dividend, providing a steady income stream. Another is the liquidation preference, which entitles the holder to receive a specific amount before assets are distributed to common stockholders.

Convertible Notes and SAFEs

Convertible notes and Simple Agreements for Future Equity (SAFEs) are common in early-stage startup financing. A convertible note is a short-term loan that converts into equity during a future financing round. A SAFE is similar but is not a debt instrument, so it has no interest rate or maturity date.

Both instruments use a valuation cap and a discount rate to determine the conversion terms. The valuation cap sets the maximum company valuation for conversion, while the discount rate allows the investor to convert their investment into shares at a reduced price compared to new investors.

Valuation Approaches for Convertible Instruments

Valuing a convertible instrument requires assessing its two parts: a debt component and an equity component. The debt portion, or “bond floor,” is the instrument’s minimum value based on the present value of its future interest or dividend payments and principal repayment. The equity option component is the value derived from the right to convert the instrument into common stock.

The instrument’s total value is influenced by factors affecting both markets; interest rates impact the debt component, while the underlying stock’s price and volatility affect the conversion option.

Sophisticated methods like option pricing models are used to value the conversion feature. The Black-Scholes model, for instance, estimates the option’s value by considering the stock’s price and volatility, time to expiration, and interest rates. A binomial model uses a tree of potential future stock prices to determine the option’s value over time.

Accounting for Convertible Instruments by the Issuer

Initial Recognition

When a company issues a convertible instrument, its treatment under U.S. Generally Accepted Accounting Principles (U.S. GAAP) is guided by standards like ASC 470-20. Recent updates have simplified this accounting. For most convertible instruments, issuers are no longer required to separate them into debt and equity components, streamlining the initial recognition process by accounting for it as a single liability or equity unit.

Subsequent Measurement

After initial recognition, if the instrument was issued at a discount to its par value, the discount must be amortized over its life. This process increases the carrying value of the debt on the balance sheet until it reaches par value at maturity. The amortization is recognized as non-cash interest expense on the issuer’s income statement, providing a more accurate picture of the company’s total cost of borrowing.

Accounting for Conversion or Extinguishment

When an investor converts the instrument, the issuer removes the debt’s carrying amount from liabilities and records the issuance of new common stock in equity. This reclassification is done using the book value method and does not result in a gain or loss on the income statement.

If the issuer repurchases the instrument before conversion or maturity, it is an extinguishment of debt. A gain or loss is recognized on the income statement, calculated as the difference between the cash paid and the debt’s carrying amount.

Tax Treatment for Investors and Issuers

At Issuance

The issuance of a convertible instrument can create an Original Issue Discount (OID) if it is issued for less than its redemption price at maturity. According to Internal Revenue Code Section 1273, the issuer can deduct the total OID as interest expense over the life of the bond. Correspondingly, the investor must recognize the OID as taxable interest income each year, even if no cash is received, treating it as a form of phantom income.

During the Holding Period

While holding a convertible instrument, any cash interest payments (coupon payments) an investor receives are treated as ordinary taxable income for that year. The issuing company can generally deduct these cash interest payments as a business expense in the year they are paid.

At Conversion

The conversion of a convertible instrument’s principal into the issuer’s stock is a non-taxable event for the investor, meaning no gain or loss is recognized on that portion. However, any shares received as payment for accrued interest are taxable as ordinary income. The investor’s tax basis in the original instrument carries over to the new shares of stock received.

Upon Sale of the Underlying Stock

The deferred tax is realized when the investor sells the stock acquired through conversion, at which point a capital gain or loss is recognized. The gain or loss is the difference between the stock’s sale price and the investor’s carried-over basis. The holding period of the original instrument is added to the stock’s holding period, which determines if the gain or loss is long-term or short-term.