Download FASB Statement 149 and Redeemable Preferred

March 2003
Private Equity
Update
An informational newsletter from the Private Equity Group
FASB Statement 149 and Redeemable Preferred
Stock
Current initiatives of the Financial
Accounting Standards Board are likely to
affect the balance sheets of private equity and
venture-backed companies. Proposed FASB
Statement 149, crafted in the wake of Enron,
WorldCom and similar scandals, will
establish rules for determining when
financial instruments must be classified as
liabilities rather than equity on a company’s
balance sheet. Specifically, the proposal
creates three new categories of instruments
that are presently characterized as equity in
most circumstances, but under FASB 149
will be characterized as liabilities. One of
these categories is particularly applicable to
private equity and venture-backed
companies, namely financial instruments,
such as preferred stock, that are manditorily
redeemable on a fixed or determinable date
1
or upon an event that is certain to occur.
Warrants with puts would be similarly
affected.
Frequently, preferred stock issued to venture
capital and private equity investors by
emerging growth companies is redeemable at
the option of the investor after a specified
date, usually at par and sometimes at fair
market value. This permits the investor to
obtain liquidity in situations in which a
liquidity event is not envisioned. In practice
preferred stock redemption rights are rarely
exercised.
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After the new FASB statement becomes
effective, all or a portion of the value of these
preferred stocks (including both newly issued
and currently outstanding preferred stock)
will have to be classified as liabilities. This
standard is currently applied to public
companies at the insistence of the SEC,
whereas the balance sheets of private
companies today show redeemable preferred
stock as equity or in a “mezzanine” category
below liabilities and above equity. As
currently proposed, FASB 149 would require
the full value of preferred stock that is
redeemable on a fixed date to be classified as
a liability. Preferred stock that becomes
redeemable after a fixed date at the option of
the holder (the most common redemption
term) would be accounted for by valuing the
put option separately and classifying that
value as a liability, while the balance would
continue to be recorded as equity. Preferred
stock that is redeemable only upon the
occurrence of a contingent event would be
classified as equity until the contingency is
resolved.
The addition of liabilities to private
companies’ balance sheets may complicate
arrangements with vendors, affect covenants
for leveraged companies and require
additional analysis of preferred stock and
option values in connection with the
preparation of quarterly financial statements.
As a result, issuers may increasingly object to
redemption terms. Even in advance of the
adoption of FASB 149, some investors are
developing alternative redemption terms
designed to keep their preferred stocks,
warrants and other instruments outside the
scope of the Statement.
We initially expected FASB 149 to be
adopted in March, but continuing debate has
delayed its issuance. We will continue to
update you on its progress.
1
The other two categories of instruments are (i) financial instruments embodying, or indexed to, an
obligation to repurchase the company’s equity shares that requires or could require settlement by transfer
of assets (e.g., written put options or forward contracts), that are physically settled or net cash settled and
(ii) financial instruments embodying an obligation that the issuer must or could settle by issuing equity
shares if the monetary value of the obligation is based solely or predominantly upon (a) a fixed monetary
amount known at inception, (b) variations in something other than the fair value of the issuer’s equity
shares, or (c) variations in the fair value of the issuer’s equity shares (e.g., a financial commitment
indexed to the S&P 500, and settable with a variable number of issuer shares and written put options
that can be net share settled).
If you would like additional information on proposed FASB Statement 149 and redeemable
preferred stock, please contact:
John R. LeClaire, P.C.
[email protected]
617.570.1144
Michael J. Kendall, P.C.
[email protected]
617.570.1765
Michael J. O’Brien
[email protected]
212.813.8875
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