We examine accounting and valuation issues for the financial instruments that fuel the booming special purpose acquisition company market.
The special purpose acquisition company (SPAC) market experienced breakneck growth over the last 15 months. More than 300 SPAC IPOs were completed in the first quarter of 2021 representing $100 billion in capital raised (compared with $83 billion raised during 2020).
SPACs are investment products that provide a mechanism for private companies to access the public capital markets. In the simplest terms, SPACs are designed as a fundraising structure with two stages. In the first stage, the SPAC entity raises capital in an IPO with the stated purpose of selecting and merging with a private company. In the second stage, the SPAC announces the merger and raises the required funds (purchase consideration) using a combination of IPO proceeds and private investment in public company (“PIPE”) financing and consummates the merger in what is known as the de-SPAC transaction.
The Securities and Exchange Commission (SEC) recently issued commentary highlighting the regulator’s concerns about the reporting requirements and internal controls in the red-hot SPAC market. Areas of scrutiny include complex financial reporting and corporate governance issues inherent in the SPAC structure.1 The SEC has also warned market participants that SPAC structures are subject to the legal liabilities for financial disclosures and reporting pursuant to securities laws that dictate IPOs and other capital market issuances.2 Most recently the SEC published a statement that specifically called into question the accounting treatment for warrants issued by SPAC entities.3 The SEC’s comments suggest that the public and private warrants issued by many SPACs should be classified as liabilities rather than as equity instruments based on the regulator’s review terms included in existing company filings. These comments may require that existing SPAC entities amend or restate their financial statements by recording the warrant shares as liabilities at fair value on the balance sheet.
In this note we address the technical accounting classification issue for SPAC warrants that has placed most SPAC filers into limbo and caused the IPO and merger market to seize. We then provide an overview of best practices for the valuation of the financial instruments created in a typical SPAC transaction: private warrants, public warrants, founders’ shares, and PIPE investments. We highlight the structural features of these SPAC instruments and recommend valuation techniques that take into account the features of the SPAC structure, such as the probability of successfully completing a merger and traditional valuation methodologies, including option theoretic models and simulation models for path-dependent options.
Determining whether a warrant should be classified as a liability (or asset) or equity under generally accepted accounting principles (GAAP) is both complex and nuanced. Under current GAAP, a warrant is accounted for as an asset or liability unless it 1) is considered to be indexed to the entity’s own equity, and 2) meets certain equity classification criteria. If both of these conditions are satisfied, the warrant is classified as equity. The recent SEC statement included examples of warrants that violated either the indexation guidance or the equity classification guidance and result in liability classification.
Generally, a warrant will satisfy the indexation guidance if it is indexed only to the entity’s own equity. Any feature that is indexed to another underlying will violate the indexation guidance and result in liability classification. Determining whether a warrant is indexed to an entity’s own equity is performed under a two-step process: 1) evaluation of contingent exercise provisions, if any, and 2) evaluation of settlement provisions.
Typically, contingent exercise provisions entitle the entity (issuer) or the holder to exercise a warrant based upon the occurrence or non-occurrence of a specified event. Contingent exercise provisions that are not based directly on the entity achieving a specific result (e.g., achieving a metric or completing a specific event) may result in a conclusion that the warrant is not indexed to an entity’s own equity. Warrants will generally meet Step 2 of the indexation guidance if the settlement amount equals the difference between the fair value of a fixed number of the entity’s shares and a fixed amount (i.e., fixed-for-fixed). In the first example cited by the SEC, the warrant failed to meet the indexation guidance because the settlement provisions are not considered to be fixed-for-fixed.
The equity classification guidance can be complex, but the basic premise is that a warrant is generally classified as a liability (or asset) if it either 1) requires net-cash settlement, or 2) allows the holder to elect either net-cash settlement or settlement in shares. Conversely, a warrant is generally classified as equity if it either 1) requires settlement in shares, or 2) allows the entity (issuer) to elect either net-cash settlement or settlement in shares. However, there are certain exceptions to this basic premise. For example, a warrant may be classified as equity if it requires net-cash settlement upon the occurrence of a change of control, provided that holders of the underlying equity receive the same form of consideration. In the second example cited by the SEC, the warrant failed to meet the equity classification guidance because the holders of the underlying equity do not receive the same form of consideration as the warrant holders in the event of a tender or exchange offer.
The implication of the recent SEC statement is that SPACs will need to re-evaluate their warrants to determine whether they fail either the indexation or the equity classification guidance, giving consideration to the examples cited by the SEC. To the extent that a SPAC concludes that warrants that were previously equity classified are appropriately classified as liabilities, prior period materiality should be assessed to determine whether a re-statement of previously issued financial statements is necessary.
SPAC vehicles are financed with a set of financial instruments that are all linked to the SPAC common share price. In the period following the SPAC IPO and prior to a merger announcement, the SPAC common shares represent an interest in a pool of capital placed in trust for the sole propose of making an acquisition within a two-year term. Following the announcement of a proposed merger, the SPAC shares can be said to represent the expectation of share in the proposed merger target (conditioned on the likelihood of closing and subject to the terms of the transaction). Finally, SPAC common shares are converted into common shares of the merged operating company (with a new stock ticker listed on the exchange) following the consummation of the de-SPAC transaction. There are three categories of SPAC financial instruments that may require independent valuations as assets of liabilities: warrants, founders’ shares, and PIPE instruments.
SPAC PUBLIC WARRANTS
A representative public SPAC warrant instrument has the following features:
|Underlying Asset Price||$10.00 at IPO, SPAC share price thereafter|
|Listing Status||Exchange traded separately 45-days after SPAC IPO|
|Conditions||All public warrants subject to extinguishment if a de-SPAC merger is not consummated|
The fair value of the public warrants may be determined by observable trading prices in the period after these instruments are listed. If trading prices are not available on a frequent basis or the warrant trading volumes are low, adjustments to observed prices may be required. For periods before public prices are observable, the fair value of public warrants can be calculated using option pricing models. We note that due to the redemption provisions for public warrants (typically $18.00 subject to certain consecutive trading price criteria), practitioners are likely to employ Monte Carlo simulation models or binominal lattice models that can accommodate path-dependent payoffs rather than the Black-Scholes option pricing model. The primary significant input to the option pricing models is the assumed volatility, which may be estimated based on observations of comparable financial instruments or other market observable information. Finally, because each of the public SPAC warrants are subject to forfeiture if a qualifying merger transaction is not completed, the calculated value of the warrant is also conditioned on the likelihood of a successful merger.
SPAC PRIVATE WARRANTS
Private SPAC warrants are typically issued to the sponsors or founders as part of a package of equity-linked instruments, referred to as the “promote.” A representative private warrant has following features:
|Underlying Asset Price||$10.00 at IPO, SPAC share price thereafter|
|Redemption Price||1. Make-whole table, if applicable
2. May include $18 redemption price
3. Founders’ warrants convert to public warrants if transferred to non-sponsor
|Conditions||All private warrants subject to extinguishment if a de-SPAC merger is not consummated|
Private or non-listed SPAC warrants can be valued by using option pricing models that use information observed or implied from the trading of the public warrants for the subject SPAC entity. For certain private warrants, the structure of these warrants is nearly equivalent to the public warrants. For example, the make-whole provisions – expressed as a warrant price payoff and based on a share price matrix and the timing of redemption in the governing documents – affect the economics of the instrument. In essence, private warrants that include the make-whole provision limit the upside for the holder. Therefore, in certain circumstances the public warrant price may provide a reasonable estimate for the value of the private warrants.
For private warrants that do not have a redemption provision, the valuation specialist will need to implement an option pricing technique to value the warrant. In this scenario, the assumed volatility is the significant input into the model. For periods in which public warrant prices are observable, the implied valuation for these instruments can be calculated by back-solving using the public warrant price. In order to reverse engineer the SPAC warrant volatility, the analyst should also consider the estimated probability that a merger will be completed by the SPAC due to the risk of forfeiture discussed previously.
SPAC FOUNDERS’ SHARES (PERFORMANCE-BASED)
|Underlying Asset Price||$10.00 at IPO, SPAC share price thereafter|
|Threshold Prices||Variable – Example of multiple tranche structure:
Tranche 1: $10.00
Tranche 2: $12.00
Tranche 3: $13.50
Tranche 4: $15.00
Tranche 5: $17.00
|Term||Exercisable for unlimited time after closing of the de-SPAC merger|
|Threshold Conditions (Path Dependent)||Variable – For example, share price must exceed the tranche Threshold price for 20 of 30 consecutive trading days:|
|Conditions||All founders’ shares subject to extinguishment if a de-SPAC merger is not consummated|
Founders shares that are conditioned on the share price hurdles also necessitate a path-dependent valuation technique. As per the stylized example provided above, many founders shares will vest in the period after the closing of the de-SPAC transaction based on stock price hurdles that require appreciation from the normalized $10.00 per share. For example, a Monte Carlo simulation can be used to generate daily share prices for the purposes of calculating the contract payoff terms for each tranche threshold. While the probability of hitting a barrier can be calculated using a closed-form equation, a simulation approach is recommended for the contingent founders’ shares to properly capture the path-dependent criteria (conservative trading day provision) embedded in founders’ shares with performance-based lockup features.
PIPE SHARES AND COMMITMENTS
PIPE investments by institutional investors provide an important bridge between the SPAC IPO (blank-check stage) and the post de-SPAC publicly listed operating company. PIPE instruments can be highly negotiated between the parties, and the terms can vary on a case-by-case basis. As with other private placement instruments, practitioners are advised to consider the contractual features of the PIPE shares that are different form the listed equity shares, including restrictions on transfers or other barriers to liquidity.
The introduction of capital from PIPE investments also can affect the value of the founder’s promote instruments and the relative ownership of public shareholders. For example, in order to induce investors to participate in PIPE equity (and to dissuade public shareholders from exercising their redemption option) to fund the proposed de-SPAC merger transaction, the SPAC sponsors will frequently relinquish a portion of the sponsor promote package (founders shares and warrants).
Finally, many PIPE investments are structed in the form of a financing commitment with a pre-determined contractual purchase price. These financial contracts can be subject to fair value adjustments when there are fluctuations in the public SPAC share price in the period between the PIPE commitment date and the PIPE funding date.
Continued SPAC Scrutiny
Given the deep reservoir of capital raised by SPAC sponsors over the last year and the recent spate of high-profile merger announcements, we expect that SPACs will remain important vehicles for accessing the public markets. However, communications from the SEC in early 2021 related to internal controls, investor communications and prospective financial information, and legal liability signal a change in the regulatory regime. Moreover, market observers have also raised important questions pertaining to SPAC performance and relative returns.4 While we focus on the narrow topics of warrant accounting and SPAC instrument valuation here, we anticipate continued scrutiny around SPAC entity and de-SPAC company financial reporting and valuations of SPAC financial instruments.
- Justin Burchett, Managing Director, STOUT
- Steve Hills, Managing Director, STOUT
Compliments of Stout – a member of the EACCNY.