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Transcript
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. Boston | New York | New Jersey | Washington DC 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 Full access to all Goodwin Procter publications is available at: http://www.goodwinprocter.com/publications.asp This publication, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. © 2003 Goodwin Procter LLP. All rights reserved.