An embedded feature modifies the cash flow of a non-derivative contract by making it dependent on some underlying measurement or event. For example, convertible preferred stock, debt agreements, and even leasing contracts frequently contain embedded features. Often, determining where embedded features exist requires searching for terms such as “right to call,” “right to put,” “right to convert,” “right to prepay,” “conditional upon,” “indexed to,” or “referenced to.” Embedded features often shift risks between an issuer and buyer to optimize contracts’ performance or incentivize one party to accept the terms more willingly. Because contracts frequently use boilerplate clauses (general clauses found in legal documents), embedded features help make contracts specific to the needs of issuers and buyers alike.
An embedded derivative is any embedded feature that requires derivative accounting treatment under ASC 815. For a feature to be classified as a derivative for accounting purposes, it must have (1) a notional amount representing the maximum possible cash flow that might be exchanged and an underlying, (2) no initial investment, and (3) a capability of being settled net, meaning that the entire notional amount is not exchanged but instead just the net change in the value of the feature is exchanged. Like a traditional derivative, an embedded derivative’s value is often based on a variable factor such as a company’s common stock price, foreign exchange rates, or interest rates. Our article Accounting for Convertible Debt goes into depth about accounting for hybrid financial instruments containing these underlyings—specifically for convertible debt. This article discusses the high-level risks associated with the accounting treatment for embedded derivatives and some common economic impacts embedded features have on their contracts.
For more information about accounting for embedded derivatives, see the Accounting Standards Codification (ASC) 815.
If an embedded feature does not meet the qualifications of an embedded derivative as shown by the accompanying chart—or the feature is closely related to the host contract—then no initial accounting treatment is required. If the feature does meet the qualifications of a derivative, companies next need to determine the specific accounting considerations associated with these embedded derivatives. Some embedded derivatives will need to be accounted for separately (bifurcated) from the host contract, which may significantly alter a company’s earnings. For example, if an embedded feature is bifurcated, the embedded piece will be valued at fair value and the changes in value will flow through a company’s earnings. Embedded derivatives that should be classified as bifurcated derivatives may not only impact earnings, but also complicate the public registration process. For instance, when a company issues a convertible note (debt that gives the holder the option to convert to common shares of the issuing company or another company), subsequent changes in interest rates or common stock prices alter the valuation of the derivative. Losses from these changes are required to be included in the income statement, which reduces earnings, and subsequent gains may offset those losses. When a pre-IPO company fails to consider the potential earnings impact of embedded derivatives under ASC 815, unexpected lower reported earnings may result in a lower valuation than previously anticipated prior to the public offering. No company anticipating going public wants these kinds of surprises.
Embedded Features may have substantial economic impacts along with the accounting considerations discussed above. In many lease agreements, revenue contracts, or debt pronouncements, embedded features complicate companies’ ability to forecast cashflows. Sometimes embedded features are triggered upon specific events occurring, such as an IPO. Understanding which features will be affected and the various financial impacts of each contract during a triggering event is essential before a company considers an initial public offering.
Terms and features triggered upon an IPO may expedite certain call, conversion, or liquidation features for debt holders. Certain liquidation features may force the issuer to redeem an instrument for cash in circumstances outside its own control. Companies must understand when an IPO (or other triggering event) may allow some of these unfavorable features to come into play, thus limiting its ability to forecast cashflows.
Understanding the economics of embedded features are of particular importance for those companies looking to go through a merger or public offering. The next sections contain examples to illustrate common embedded features in practice and economic considerations for companies pursuing a public offering.
Greenshoe options, or over-allotment options, are usually features embedded in an IPO prospectus statement. A greenshoe clause is very common and provides liquidity for the new publicly traded company. This embedded option typically allows investment banks underwriting the IPO, or the syndicate, to legally stabilize the price of the shares it will sell after the public offering, creating liquidity.
A greenshoe clause is essentially a call option for the investment banks. Generally, in an IPO transaction, the underwriter shorts the offering size by issuing more shares to the public than it originally planned. For example, an underwriter may sell 110% of, say, $20 shares, which means the syndicate has a short position of 10% of the total shares. In a scenario where the stock price drops to $15, the investment bank does not exercise the over-allotment option, but buys back its short position (the extra 10% of the total shares) at a discount and makes $5 on each of the shares.
In a scenario where the stock price immediately rises from $20 to $25, the underwriter will exercise its greenshoe option and buy the shares for $20 to close its short position. This embedded feature helps to legally smooth out the price volatility during an IPO. Companies looking to go public should be aware of these features that investment banks often include in their contracts for the public equity offering.
Greenshoe options may benefit or negatively impact a company issuing shares to the public. When the post-issuance price rises, the syndicate uses the greenshoe option to stabilize the price of the shares, thus limiting the drastic growth of the share price; this harms the public perception of the issuing company. On the flip side, when the price drops soon after the issuance, the greenshoe option may benefit the company by not spooking investors made nervous by a quick post-issuance decline in stock price.
Down Round Features
A down round feature is an anti-dilution provision, which can be either a freestanding or an embedded feature. This feature seeks to protect investors from declines in value. Down rounds are very common in convertible preferred shares and convertible debt instruments.
For example, suppose a private company issued warrants that allow the holder to buy 100 shares of its stocks for $15 per share. These warrants also have an embedded down round feature to protect investors from its common stock price dropping. The down round feature specifies that if the company issues more common stock for an amount less than $15 per share, the strike price of the warrants would be set to the lower strike price for more-recently issued warrants. In our example, suppose this new strike price is $12 per share.
Now, in a separate transaction, suppose the private company issues common stock for $10 per share. The down round feature on the original warrants would kick in, and the strike price would be reduced for the warrants to $12 rather than the original $15 strike price. Thus, down round features can alter the fair value of financial instruments. When third parties can redeem warrants for common stock, the equity (or liabilities of the company depending on how the warrants are classified) need to be adjusted accordingly with gains and losses running through the income statement. Down round features alter companies’ prior warrant issuances, which many may not consider prior to an IPO.
Features Contingent on IPO
Some embedded features hinge on an IPO or other event. For example, a company may issue warrants to purchase preferred shares at $10 per share. An embedded clause may say that in the event of an IPO, the preferred shares are puttable at 80% of the IPO price. This causes the embedded feature to turn on some event—in this case an IPO. In this situation, the new public company must understand that all parties who have the aforementioned warrants will be able to acquire ownership for less cash than everyone else once the shares become listed. If the issuing company was not aware of this possibility, they may now regret issuing those preferred shares with the embedded features.
A price reset option is a derivative that has a payoff depending on the historical prices of underlying assets. This option will protect investors from economic downturns, which puts the risk on the company rather than on the investor. Option pricing models reflect these options when used in estimating their fair value. Identifying the outstanding reset options embedded in contracts is important to understanding what the company’s risks are when price reset options are embedded in contracts.
Conversion options are another type of feature that allows the buyer to transform one investment to another form of investment (such as converting preferred stock to common stock). For example, if an investor owns a convertible bond worth $100 and the bond can convert to 10 shares of common stock due to the conversion option embedded in the bond prospectus, the investor will likely convert to common stock when the stock price exceeds $10 per share. Understanding this feature can assist companies’ predictive analysis of how its debt and equity accounts may fluctuate.
Ultimately, embedded features are a part of many financial instruments and contracts. Understanding the accounting treatment and economic impacts of these features is crucial, especially for a company looking to go public. If the embedded feature is bifurcated, the embedded piece will be valued at fair value and run changes through earnings. Whether the features consist of price resets, anti-dilution provisions, or down round features, understanding how instruments’ valuations change with various features is invaluable.