In exchange for assets sold (FMV of 800K), we accepted a note receivable with detachable warrants. Notes mature in 3 years, 0% interest and are automatically convertible to preferred shares of a private company equivalent to the face value of $1M, with a maturity term of 3 years. Along with the note is a warrant for 100 shares of preferred stock at an exercise price of $1/share with a term of 5 years. How would you account for this transaction. The only FMV known is the assets sold.
Investor receives debt security with detachable warrants in exchange for assets
Answers
I'm not a
Hoping this is a good starting point for you to chat with your Audit Partner.
You should have a valuation on the stock for reporting purposes (123r, 409a), or have had a prior sale of the pref shares.
With that you can back into the "what is a 5 yr. / $1 Strike warrant worth" using BS or other similar method. (note, a normal 123r valuation doesn't look at the preferreds, just the common, so you'd need to back into it)
Deduct that from the $800K (let's say it is $100K) and you net out to what has been paid for the notes (in this example $700K), separate from the warrants.
From there you get implied interest that you can expense over the term of the note ($300K). While you can back into the compound interest calculation, I'd not bother and just straight-line it.
What I'm unclear on here is the final part: that $1m of pref stock. Is is $1m now? If so, it's another warrant valuation question that needs to be fed through the cycle above, as we don't know what those future shares will be worth when we sell them. If it is $1m at the then-current valuation, then it is more like a straight as-if-it-were-cash liability, that needs only a determination of how you will arrive at that price in the future.
If it is the latter, then your transactions are:
DR: $800K assets.
CR: $100K Warrant.
CR: $700K Note
Then, monthly:
DR: $300K/36 Interest Expense
CR: $300k/36 Interest Accrued
Finally, upon note conversion:
DR: $1M Note/Interest
CR: $1M Pref Stock Liability
One thing to note here: if there is a significant down-round, and you're doing the pref stock at the then-current price, you could be giving up more of the company than you had planned. This doesn't sound as harsh/dangerous as the old Death Spiral Convertible**...but seems like it may have some of the characteristics of that, so I'd advise caution that the $1M doesn't turn out to be a much bigger % of your company than you'd originally hoped.
**If you're not familiar with this structure, it is worth reviewing.
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