Chapter 6 — Other Common Embedded Features

6.3 Conversion Features in an Equity Host

6.3.1 Background

An equity instrument often contains features that require or permit the instrument to be converted into another form of the issuer’s equity. The most common scenario is a preferred stock agreement that contains a feature allowing holders to convert their preferred shares into common stock (1) at the option of one of the parties to the contract, (2) upon the occurrence of certain events, or (3) after a certain period of time. As discussed in greater detail below, equity conversion features generally do not require bifurcation from an equity host contract because such features are considered clearly and closely related to the host contract.

A financial instrument may contain a term that is described as an equity conversion or exchange feature but economically represents a share-settled redemption or indexation provision whose monetary value does not vary on the basis of a stock price or stock price index. The number of equity shares is variable and is calculated to be equal in value to a fixed or specified monetary amount (e.g., the original issuance price of the preferred stock plus accrued and unpaid dividends) or a monetary amount that is indexed to an unrelated underlying (e.g., the price of gold).

Even if the terms of the instrument refer to the share-settled feature as an equity conversion or exchange feature, the entity should not analyze it as such since it does not have the economic payoff profile of an equity conversion or exchange feature. Instead, the entity should (1) evaluate the feature as a put, call, redemption, or other indexed feature, as applicable, and (2) determine whether the feature must be separated as a derivative instrument under ASC 815-15. (An instrument issued in the form of an equity share [e.g., preferred stock] should also be evaluated to determine whether the feature results in the requirement to classify the instrument as a liability under ASC 480-10; see Chapter 6 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.) For further discussion of how to evaluate embedded redemption features in an equity host contract for bifurcation, see Section 6.5.

Example 6-4

Preferred Stock Settleable for Variable Number of Shares Upon a Qualified Equity Financing

Tech Co. issues preferred stock that includes a feature that calls for “conversion” into the issuer’s common stock upon a qualified equity financing. The conversion price is defined as 85 percent of the per-share price of common stock in the qualified equity offering. Assume that the preferred stock contains an equity host for the purpose of performing the evaluation of embedded features for bifurcation.

Although the contract refers to the feature as a conversion feature and it must be settled in shares of common stock, the instrument should not be analyzed as an equity host with an equity conversion feature because the monetary value of the shares delivered upon conversion is unrelated to the fair value of the issuer’s equity shares. Rather, this feature provides the holder with a fixed payoff and therefore should be evaluated under ASC 815-15 as a contingent redemption option; it would not be evaluated as a conversion feature even though it is settled in the issuer’s equity shares.

See Example 6-10 for further discussion of whether this feature would require bifurcation.

6.3.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of equity conversion features embedded in an equity host contract. As previously noted, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 4.3.2)	No	A conversion feature that allows a hybrid instrument in the form of a share (e.g., preferred stock) to be converted into another type of the entity’s equity (e.g., common stock) is considered clearly and closely related to the equity host contract. In addition, cash-settled conversion features are similarly typically considered clearly and closely related to an equity host since the monetary value of the cash conversion is based on the value of the equity shares.
Hybrid instrument not measured at fair value through earnings on a recurring basis (see Section 4.3.3)	It depends	From the issuer’s perspective, equity host contracts would not be measured at fair value on a recurring basis since they are not eligible for the fair value option in ASC 815-15 or ASC 825-10. Legal form equity contracts that require liability classification (and thus are potentially subject to recurring fair value measurement) would not typically be considered equity hosts in the evaluation of embedded features. From the holder’s perspective, the determination of whether the hybrid instrument is measured at fair value, with changes in fair value recorded through earnings, will depend on whether the instrument is (1) an equity method investment, (2) considered a debt security within the scope of ASC 320 (and whether the holder has elected to apply the fair value option), or (3) an equity security within the scope of ASC 321.
Meets the definition of a derivative (see Section 4.3.4)	It depends	The conversion of a hybrid instrument in the form of a share (e.g., preferred stock) into another form of an entity’s equity may meet the definition of a derivative if both the host contract and the instrument issued are RCC. In addition, the feature may meet the definition of a derivative if the conversion feature could be settled in cash. See Section 6.3.4 for further details.
Meets a scope exception	It depends	The issuer should evaluate whether the equity conversion feature meets the scope exception for certain contracts on own equity or share-based payment transactions. Conversion features that can be cash settled in a manner outside the issuer’s control would generally not qualify for this scope exception.

6.3.3 Clearly-and-Closely-Related Analysis

A conversion feature that allows a hybrid instrument in the form of a share (e.g., preferred stock) to be converted into another type of an entity’s equity (e.g., common stock) is considered clearly and closely related to an equity host contract. In addition, a conversion feature that can be settled in cash or shares would also be considered clearly and closely related to the host contract because the monetary value of the conversion, regardless of the form of settlement, is based on the monetary value of the equity shares. Accordingly, cash-settled conversion features are also typically considered clearly and closely related to an equity host.

Because the “not clearly and closely related” criterion is generally not met for conversion features in an equity host contract, most entities would not be required to evaluate whether the conversion feature meets the definition of a derivative. Despite that practicality, we discuss the derivative considerations for illustrative purposes in the following section.

6.3.4 Derivative Analysis

The table below presents the characteristics that would be evaluated to determine whether an equity conversion feature embedded in an equity host would meet the definition of a derivative. In a manner consistent with conversion features in a debt host, the determination often comes down to whether or not the feature meets the net settlement criterion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision	Yes	An equity conversion or exchange feature has both an underlying (the fair value of the equity instruments that would be issued upon conversion and, if applicable, the occurrence or nonoccurrence of any exercise contingency) and a notional amount (the number of shares that would be issued upon conversion).
Initial net investment	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the equity conversion feature on a stand-alone basis without the host contract). Generally, an equity conversion or exchange feature has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in the stock price (since the investment in the equity host contract does not form part of the initial net investment in the embedded feature).
Net settlement	It depends	The net settlement characteristic is met if either (1) the equity conversion or exchange feature can be explicitly net settled (e.g., its fair value can be settled net in shares or net in cash) or (2) the shares that would be issued upon conversion are RCC. Shares of publicly traded entities may be considered RCC; however, non-publicly-traded shares will never be considered RCC (see Section 1.4.3.4 for further discussion of RCC). The net settlement characteristic is not met if the equity conversion or exchange feature must be gross physically settled and the shares that would be delivered upon conversion are not RCC. See Section 6.2.4.3 for further discussion of net settlement considerations for equity conversion features.

6.3.5 Scope Exception for Certain Own Equity Contracts

As discussed in Section 2.3.11, ASC 815-10-15-74 describes a scope exception that can potentially be applied to an entity that issues a contract that is settleable in its own equity. The issuer of a convertible equity instrument should evaluate whether this scope exception may be applicable; however, this scope exception would never be available to the investor in the same instrument. In other words, a company that issues preferred stock that is convertible into shares of common stock may potentially be eligible for this scope exception, but the investor in the same convertible preferred stock instrument would not be eligible for such exception.

See Deloitte’s Roadmap Contracts on an Entity’s Own Equity for a comprehensive discussion of the relevant guidance.

6.3.6 Scope Exception for Certain Share-Based Payment Transactions

As referenced in Section 6.2.6, ASC 815-10-15-74(b) indicates that a contract issued by an entity that is subject to ASC 718 would not be subject to the guidance in ASC 815. Under ASC 718, share-based payment arrangements generally remain within the scope of ASC 718 throughout their lives, provided that they are not modified after they are issued to grantees.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.