US GAAP: Liability vs. Equity Classification of Public Warrants Issued by a SPAC

In its initial public offering (IPO), a special purpose acquisition company (SPAC) typically issues units to third-party investors at $10.00 per unit. Each unit generally contains a fraction of a warrant to purchase a Class A common share (commonly referred to as a “Public Warrant” or a “Redeemable Warrant”).

To determine the appropriate classification of the Public Warrants, SPACs must address the following accounting questions:

1.      Does the Public Warrant represent a freestanding financial instrument, and therefore should it be evaluated for liability under FASB ASC 480, Distinguishing Liabilities from Equity (“ASC 480”)?

2.      Should the Public Warrant be classified liability under ASC 480?

3.      Is the Public Warrant required to be accounted for as a derivative (i.e., liability) under FASB ASC Topic 815, Derivatives and Hedging ("ASC 815")? In other words, does the Public Warrant meet the derivative scope exception under ASC 815 (specifically under ASC Subtopic 815-40 (“ASC 815-40”))?

Q1. Does the Public Warrant represent a freestanding financial instrument, and therefore should it be evaluated for liability under ASC 480?

Yes. “Although initially issued as a unit, the Class A Shares and Public Warrants become separately tradable shortly after the IPO. In addition, upon exercise, the Public Warrants do not alter the terms of the Class A Shares previously issued. Therefore, the Public Warrants (1) are legally detachable and separately exercisable from the Class A Shares issued as part of the units and (2) meet the definition of a freestanding financial instrument in ASC 480-10-20.” [source: see below]

Continue to Q2.

Q2. Should the Public Warrant be classified liability under ASC 480?

The evaluation of whether Public Warrants are liabilities under ASC 480 will generally depend on when the warrants become exercisable:

·         The Public Warrants may be exercised before a merger with a target.

Yes, because the Class A common shares received upon exercise of the warrants may be redeemed at the holder’s option upon a merger of the SPAC. The SPAC is obligated to use its best efforts to complete a merger. [ASC 480-10-25-8]

·         The Public Warrants may be exercised only after a merger with a target.

No, because once the warrants are exercisable, the holder will receive Class A common shares that are not redeemable. Note that once a merger with a target is completed, the holders of Class A common shares no longer have any ability to redeem their shares. [ASC 480-10-25-8]

Note: The SPAC should further consider whether the Public Warrants represent an obligation to issue a variable number of equity shares whose monetary value is based solely or predominantly on (1) a fixed amount, (2) variations in something other than the fair value of the Class A common shares, or (3) variations that are inversely related to the fair value of the Class A common shares, which would represent liabilities. [ASC 480-10-25-14] However, in practice, this would be unusual.

Continue to Q3.

Q3. Does the Public Warrant meet the derivative scope exception under ASC 815-40?

Public Warrants generally meet the definition of a derivative under ASC 815. However, SPACs should evaluate whether such warrants meet the derivative scope exception under ASC 815-40.

To meet the derivative scope exception, and therefore to be classified as equity under ASC 815-40, the Public Warrants must meet the following two requirements:

• They are indexed to the SPAC’s stock. [“Indexation” requirement]; AND

• They meet the criteria for equity classification (i.e., the SPAC controls the ability to settle the warrants in shares). [“Equity Classification” requirement]

The devil is in the details! Public Warrants typically contain multiple features (e.g., settlement provisions) that must be evaluated individually by SPACs. If any one of the features prevents the Public Warrants from meeting both Indexation and Equity Classification requirements, they may not be classified in equity and must be classified as derivative liabilities. The guidance in ASC 815-40 is complex to apply. Therefore, consultation with an entity’s accounting advisers is encouraged.

 

Source: Financial Reporting Alert 20-6, Accounting and SEC Reporting Considerations for SPAC Transactions (October 2, 2020; Last Updated March 25, 2021)