December 19, 2017
Early-stage companies, often long on optimism but short on cash, have looked for creative ways to pay or incentivize vendors and customers without reducing their bank account. One method that was prominent in the 1990s was granting equity – usually warrants – as a form of payment to cover consulting fees, royalties or even pay the rent. Many early-stage companies embraced this approach until a new accounting rule made the potential P&L impact quite dilutive, essentially putting the kibosh on this practice. However, warrants may be poised for a comeback, thanks to a potential rollback of the onerous P&L result.
Warrants allow a holder to participate in the upside of the issuer. In the case of a home run, warrants could be worth many times what the holder would have received in cash for their goods or services. If the company fails, the warrants would be worthless, but many partners would be happy to take that risk, especially during the 1990s boom.
During that time, officials responsible for setting US accounting standards largely curbed the use of warrants by establishing a new approach. This approach, which remains in effect today, requires in almost all cases the cost of the services to be measured using the fair value (e.g., mark-to-market) at such time as the delivery of services is finished (e.g., beta testing of new technology is successfully completed). In the case of a rising equity valuation, the cost of these services would skyrocket – hitting the issuer’s P&L, sometimes even as a reduction of revenue (taboo for a startup) if the warrant holder is a customer.
What’s potentially changing?
As we speak, the Financial Accounting Standards Board (FASB) is looking to align the measurement of warrants granted to non-employees with that applied to employees, meaning the potential expense is locked in at the grant date. One cautionary note is that this change can, in certain circumstances, result in earlier recognition of that expense in earnings than is the case under today’s guidance. But overall this change is a win-win for a company, as it prevents expenses from escalating and minimizes potential earnings volatility down the road. At the same time, it wouldn’t change the accounting or economic attractiveness of these instruments for vendors, customers, consultants and other business partners.
The FASB decided in mid-December 2017 to move forward with finalizing the new rule after considering the broad support and feedback it received on the proposal. If the rule change is finalized in a timely manner, it may even be possible to adopt the changes in 2018. Alternatively, public companies will be required to adopt the change in 2019, and private companies will have an additional year to comply. Given that, companies and their advisors may want to keep this one on their radar, especially when negotiating new alliances or business arrangements where equity upside may help cement a deal.