Hybrid Instruments with Embedded Conversion Features

“Progress is man’s ability to complicate simplicity.” Thor Heyerdahl

Convertible bonds and preferred stock are popular instruments that cash-starved businesses use to raise capital when other more traditional financing methods are not available. These instruments provide much-needed liquidity to high-risk entities while often enticing investors with embedded conversion features (“ECF”) that offer the prospect for upside in the event the company is successful.

Under current GAAP, the literature for determining how to account for instruments with embedded conversion features is complex. Challenges include measuring the impact of variable conversion prices and vesting events that are uncertain (such as performance milestones and other contingencies) and that can greatly impact value under certain scenarios.

Combine the complexity of the accounting rules for derivatives with the frequent relative lack of accounting sophistication of many of the companies that issue them, and you have a perfect storm for potential misstatements. The SEC cites embedded conversion options as a perennial top subject of financial reporting issues raised in SEC comment letters.

One common stumbling block I have seen is practitioners’ failure to account for the potentially dilutive effect of embedded conversion features on the underlying share price of the Company immediately following conversion. Many companies have significant options outstanding that may provide the holders with a meaningful stake in the business when converted, particularly when the conversion price is not fixed but rather based on historical stock price of the company (as in a look-back period). If the strike price is well below the underlying stock price, the conversion creates disproportionately more shares without a corresponding increase in the value received by the company, and as a result the stock price takes a hit. The failure to account for this dynamic can significantly overstate the ECF liability. The SEC has a good article on the dangers of these so-called “death spiral” convertibles here: http://www.sec.gov/answers/convertibles.htm

Valuing convertibles with complex conversion features often calls for the use of a Monte Carlo simulation with multiple assumptions and moving parts. In these situations, it is important to step away from the model and form an “educated guess” on the expected range of value for the hybrid security. If, for example, a company is has going concern issues (as many convertible debt issuers do), yet the implied fair value of an ECF exceeds the face value of the debt or the liquidation value of the preferred shares, it is worth revisiting the assumptions used and running through a few simulations the old fashioned way, on the back of a napkin. If the back of the napkin does not provide enough space to calculate the impact of a few different scenarios, then perhaps the complexity of the model has outgrown its usefulness.