Company founders have more options than ever when it comes to financing their company. It is important to find capital that matches the company’s objectives and timelines. That means not only finding financing for today, but also projecting future capital needs and making plans accordingly. Tranched preferred stock is a potential financing vehicle for companies that need capital now and will need more capital at specific moments in the future. This article gives a brief background on preferred stock and goes on to describe the unique characteristics of tranched preferred stock.
Preferred stock represents, in legal form, an ownership relationship as opposed to a creditor relationship. Preferred stock is distinguished from common stock in its preferred priority in receiving proceeds in case of bankruptcy, but, like common stock, preferred stockholders would receive consideration only after all creditors have been paid. A similar preference may exist in terms of payment of cash dividends; preferred stockholders may receive their dividends in full before any dividends are paid to the common stockholders. Preferred stock comes in many variations, some of which can give it debt-like characteristics. Preferred stock can be redeemable, have stated dividend rates, and/or be convertible into common stock. Other preferred stock issues are perpetual and have no stated dividend rate.
Tranched Preferred Stock
Tranched preferred stock, also called a “delayed issuance of preferred shares” or a “contingent issuance of preferred shares,” consists of at least 2 components. The first component is an initial issuance of preferred shares. The second piece is the future issuance of preferred shares, which is contractually agreed upon at the closing date of the initial issuance. The subsequent issuance is called a tranche. This future issuance will be made upon a specific date or upon the completion of a certain event or milestone. There can be multiple issuances, or tranches, after the initial issuance.
Company Benefit From Tranched Preferred Stock
The appeal of tranched preferred stock to companies is the guarantee of future funding at key dates or milestones. This guaranteed future financing can be particularly relevant to companies with high research and development costs. Emerging tech companies can plan on funding throughout the product design process. Companies that have important regulatory hurdles, such as biotech and pharma companies, can plan investment around those events. These companies can ensure they have funding for clinical trials before regulatory approval or funding for production after approval.
Investor Benefit From Tranched Preferred Stock
Investors can benefit from tranched preferred stock because they can make subsequent funding contingent upon certain dates or company milestones. An investor that is financing a biotech company with a therapy in the approval process with a government agency like the FDA is a good example. The investor wants to help finance the research and development of the therapy, but the investor would also like to mitigate the risk associated with such an investment. If the FDA approves it, the therapy becomes much more valuable, and having the ability to make future investment contingent on FDA approval helps reduce risk for the investor. Such an arrangement allows the investor to gain more upside for less capital because as the company increases in value the contractual obligations of the amount required for future preferred share issuances doesn’t change.
Mechanics of Tranched Preferred Stock
The subsequent tranche can be (1) a forward contract (the issuer must issue, and the investor must purchase shares in the future, either on fixed or determinable dates or potentially upon the resolution of future contingencies), (2) a purchased put (issuer has the right but not the obligation to issue additional shares), or (3) a written call (investor has the right but not the obligation to purchase additional shares) on the preferred shares. The timing of the subsequent tranches can be determined by a specific date or the occurrence of a specific event. The following timeline shows when the issuances occur.
Accounting for Tranched Preferred Stock
Accounting for tranched preferred stock requires careful analysis. The first step is to determine if the subsequent issuances are freestanding financial instruments or embedded features of the original issuance. A freestanding financial instrument is defined in ASC 480 as an instrument that meets one of two conditions: (1) it is entered into separately and apart from any of the entity’s other financial instruments or equity transactions or (2) it is entered into in conjunction with some other transaction and is legally detachable and separately exercisable. Since the tranches are agreed upon at closing, they must be analyzed under the second condition to determine if they are legally detachable and separately exercisable.
Legally detachable generally means that the different instruments (in this case the original issuance and the future issuances) can be held by separate parties. If the original investor can sell the preferred stock but maintain the tranche rights, the instruments are legally detachable. To determine what rights are available to each party, it may be necessary to involve legal counsel.
Separately exercisable generally means that one instrument can be exercised without terminating the other. If the tranche rights can be exercised and the original preferred stock can remain outstanding, the instruments are separately exercisable. This is generally the case for tranched preferred stock, but once again, it is wise to involve legal counsel to determine with certainty.
If there are multiple tranches, each tranche will need to be analyzed under the legally detachable and separately exercisable guidance. It is possible that the tranches are freestanding from the initial issuance, but multiple tranches may collectively represent a single freestanding instrument. It is also possible that the tranches are all individual, freestanding, financial instruments.
Assuming there is one freestanding tranche and the original issuance, there are two instruments to account for. The first step is to determine the proper classification of the freestanding future tranche right or obligation instrument (as an asset or liability or in equity). If the freestanding tranche imposes—conditionally or unconditionally—an obligation on the company to issue shares that are potentially redeemable outside the company’s control, the freestanding tranche is classified as a liability pursuant to ASC 480. The potential redemption of the underlying shares is beyond the scope of this article.
Assuming the tranche rights are not liabilities under ASC 480, they must be analyzed under ASC 815-40 to determine the appropriate classification. A tranche right would qualify for equity classification if it were (1) indexed to the entity’s own stock and (2) met the equity settlement conditions. If the tranche right is a liability under ASC 480 or an asset/liability under ASC 815-40, it is generally marked to fair value at each reporting date. If a tranche right is classified as equity, it is allocated its relative fair value from the proceeds of the initial issuance and is not adjusted for fair value changes as long as it remains in equity.
If the tranche right is determined to be an embedded feature of the original preferred stock, it must be analyzed under ASC 815-15 to determine if the feature must be bifurcated (see our article on embedded features here). The conclusion to bifurcate or not may have to be reassessed at each subsequent reporting date.
Tranched preferred stock offerings help give founders and operators a reliable source of financing at key dates and events in the future. Company operators in R&D-intensive industries (such as tech or pharma) with products that have discrete development milestones should consider tranched preferred stock as an opportunity to raise capital for now and in the future.