Intrinsic has assisted many publicly traded (and privately-owned) clients over the years in the valuation of complex securities for financial reporting purposes under GAAP and IFRS regulations. “Complex Securities” in this context refers to variations of warrants, convertible debt, restricted stock units (“RSU”) and performance shares based around a total shareholder return (“TSR”) mechanism.
In addition to the complex accounting codifications surrounding these securities, public and private companies should be aware of the valuation considerations and methodologies behind the accounting. Generally, two primary tools are used to arrive at the fair value of these securities for accounting purposes: Lattice Models and Monte Carlo Simulation methods. We discuss best practices across the three general security types below.
A warrant gives the holder the right, but not the obligation, to convert into a common security at a predetermined exercise price (or exercise formula). We refer to warrants containing a fixed strike price with no special conversion features as “Plain Vanilla” warrants, which can generally be valued for financial reporting purposes under a Black-Scholes option pricing methodology. The inputs to this model are performed internally by our clients in many cases, using the following key inputs: i) term, ii) volatility, iii) stock price, iv) strike price, v) risk-free rate and vi) dividend yield.
However, we come across warrants with complex features such as down-round protection (i.e. allowing for a partial or full reduction of exercise price upon the issuance of dilutive securities), variable strike prices, and call and redemption features granted to the holder and/or issuer. In the case of these complex warrants, variates of the binomial lattice model are the most effective valuation methodology. Put simply, the model forecasts a wide range of underlying asset values via a price tree (with individual branches of the tree being “nodes”), which is then used to determine future asset values at each node. These asset values are then discounted to arrive at the present value of the asset.
Given that the holder of the warrant has the choice to convert into a common security, lattice models consider the most logical and economical decision for the warrant holder and issuer throughout a holding period: this logic is referred to as “backward induction”. The lattice model can also be augmented with a Monte Carlo Simulation. For instance, when certain events, such as an IPO of the issuer or a down-round event, influence the contractual exercise price or down-round protection provisions, Monte Carlo decision logic can be embedded in a Lattice Model to account for the underlying probability of an adjustment to the contractual exercise within the lattice structure.
Convertible debt valuation issues arise in the public domain when a conversion feature is embedded into a debt instrument with a set maturity date, which gives the holder the right to collect principal and interest, in addition to the option to convert principal and/or interest into common securities. No two convertible notes are identical in the public space, and the accounting guidance under ASC 815 and 480 requires a special attention to detail and accounting judgment. In many cases, the conversion feature embedded in a debt host instrument may require bifurcation and a separate accounting treatment from the debt host.
Intrinsic is involved in many convertible note valuations when bifurcation is required, notably when the instrument is structured with puts or redemption features, down-round protection, or variable exercise prices. Similar to the valuation of warrants, the tool of choice is generally a Lattice Model, which has the ability to account for the economical decision of the issuer or holder to take action (hold, convert, redeem, etc.) through backward induction. The Lattice Model can also account for the present value of principal and interest paid as a part of the debt host. When convertible notes are structured with unique, path-dependent features, a Monte Carlo Simulation can be applied to the framework.
RSU and TSR Securities
Many public companies issue RSU and TSR securities to employees to incent stock price growth and strong stock price performance versus publicly traded peers. For instance:
• RSU compensation plans may grant the right for RSU units to convert into an escalating number of publicly traded common shares as stock performance grows into higher thresholds over a prespecified period.
• TSR Plans generally contain a “share performance grid” which grants employees an escalading number of common shares as relative stock price performance falls in higher thresholds versus a basket of peer stocks.
In many cases, the liability associated with these plans is recognized on the balance sheet in quarterly filings, with an associated expense on the income statement. Generally, the best quantitative framework to value RSU and TSR liabilities is a Monte Carlo Simulation. Specifically, the subject stock price is forecasted using a random walk via a risk-neutral Geometric Brownian Motion approach. The key input in this model is volatility, which is determined through the subject stock’s historical and implied volatility, and the volatility of a basket of peers, when appropriate. If needed, the Monte Carlo Simulation also can incorporate a correlation factor with a peer group of stocks and broad economic indicators.
Prior to issuing securities, valuation and accounting considerations associated with these unique instruments should be discussed with auditors and valuation professionals. In many cases, notably with convertible debt, the accounting issues can be complex, and each unique contract feature must be evaluated from a valuation perspective.