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How to Account for Beneficial Conversion Features

Early stage technology companies frequently seek outside financing in order to grow their business. It is usually difficult to obtain financing with favorable terms since many start-ups do not have the revenue or assets to support such terms.

Under these circumstances, companies may utilize debt financing with a beneficial conversion feature in order to obtain financing at a more favorable interest rate.  Beneficial conversion features are frequently found in convertible debt (and equity) securities, and it is important to understand what that means for your Company. The following is the basic accounting for beneficial conversion features related to convertible debt securities.

A convertible debt security is a debt instrument that offers the holder of the security an option to redeem  the instrument, in whole or in part, for cash at maturity or to redeem the instrument for stock in the company. The holder cannot both convert the debt into equity and redeem the debt; he or she must do one or the other.

A beneficial conversion feature related to convertible debt exists when the debt may be converted into stock at a lower conversion rate than the current value of the underlying equity.  Conversion rates take two forms:

  1. A fixed rate at the commitment date, for example the holders may purchase shares for a stated rate of $1.25; or
  2. A fixed discount to the market price of the stock at the date of the conversion, for example 80% of the value of the underlying equity on the date of conversion.

When converting debt into shares at a lower cost than the cost that is offered to the current market, the debt holder is recognizing a benefit for the price difference in those shares, which represents the share’s intrinsic value. At the same time, the Company that borrowed the debt must recognize a cost related to this feature. This cost is recorded in equity because it is considered an additional cost of financing.

In most cases, conversion features are recognized at the issuance date of the debt separately from the debt by allocating a portion of the proceeds that are equal to the intrinsic value of the feature to additional paid-in capital and recording a discount to the debt.  The debt discount is then amortized to interest expense monthly over the life of the debt, or until conversion.  In the event that the debt is converted prior to maturity, the remaining discount is expensed to interest as of the date of the conversion.

Primary Forms of Conversion Features

There are two primary forms of conversion features, active and inactive, or contingent conversion features.

Active conversion features exist when the holder of the debt security can convert the debt immediately into an existing series of stock.

Contingent conversion features (inactive) are based on future events such as a liquidation or change in control of the entity, the issuance of a subsequent round of funding, or an initial public offering. This type of feature is measured when the value can be calculated, and is calculated in the same manner as active conversion features and recorded as of the date the contingency is resolved.

Once the beneficial conversion feature is measured, it is not recorded until the contingency is resolved, or the series of shares that the note is convertible into is available. At that point, a debt discount is recorded and interest is then amortized from the date of resolution to the maturity or conversion date.

Rule of thumb
In the event both active and contingent beneficial conversion features exist, the beneficial conversion feature should not be recorded until the new series of equity is issued that the debt is convertible into. If you calculate the beneficial conversion feature on both, you are double-counting the feature since the Company cannot convert in both scenarios, only in one. If the Company elects to record the active feature and the note holders ultimately convert under the inactive feature, then the incremental value of the inactive beneficial conversion feature should be recorded.

Many times convertible debt is not only issued with a beneficial conversion feature, but with additional benefits, such as a warrant. In the event this occurs, the proceeds from the debt first must be allocated to all instruments before the beneficial conversion feature is calculated.

Melissa Crowe, CPA
View Experience

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