Chapter 6 — Other Common Embedded Features

6.5 Call, Put, and Other Redemption Features in Equity Hosts

6.5.1 Background

Redemption features in an equity host can take many potential forms, including put and call options and share-settled redemption options. Such redemption features could be exercisable (1) at the option of the holder or the issuer or (2) automatically upon the occurrence of certain contingent events. An entity should understand the specific terms and provisions of the redemption feature before evaluating whether it is clearly and closely related to the equity host. We discuss application issues related to such features embedded in debt host contracts in Section 6.4.

Equity host contracts often contain a provision related to liquidation preference, which stipulates the amount of cash or other assets a holder of the equity shares would receive upon the final liquidation or winding up of the entity (i.e., an “ordinary liquidation”). The existence of a liquidation preference provision does not in itself represent an embedded feature that must be evaluated for possible bifurcation. However, if redemption would occur upon certain “deemed liquidation events” that do not result in the cessation of the entity’s operations, such as a change of control or sale of the issuer, the entity would be required to evaluate the provision as a possible embedded derivative.

6.5.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of redemption features embedded in an equity host contract. 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	Yes	Put and call options are not considered clearly and closely related to an equity host contract since the risks and rewards of a fixed settlement upon redemption are not clearly and closely related to the risks and rewards of an equity interest. In the evaluation of this criterion, an entity should consider the payoff profile of the settlement (see Section 4.2.2) rather than the form of settlement (i.e., cash versus shares).
Hybrid instrument not measured at fair value through earnings on a recurring basis	It depends	From the issuer’s perspective, equity host contracts are not 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, depends 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	It depends	The determination of whether a redemption feature embedded in an equity host meets the definition of a derivative often depends on whether the feature meets the net settlement criterion — specifically, whether the underlying instrument (e.g., preferred stock) is RCC. The gross exchange of an equity host instrument that is not RCC for cash does not inherently meet the net settlement criterion.
Meets a scope exception	No	From the issuer’s perspective, the issuer should evaluate whether the redemption feature meets the scope exception for certain contracts on an issuer’s own equity. For example, a redemption feature that allows the issuer to call an equity instrument at a fixed price (i.e., a physically settled reacquisition of its own equity) may meet this exception if the option doesn’t fail any of the criteria in ASC 815-40 (see Section 2.3.11). From the holder’s perspective, a scope exception is not applicable.

6.5.3 Clearly-and-Closely-Related Analysis

ASC 815-15

25-20 A put option that enables the holder to require the issuer of an equity instrument (which has been deemed to contain an equity host contract in accordance with paragraphs 815-15-25-17A through 25-17D) to reacquire that equity instrument for cash or other assets is not clearly and closely related to that equity instrument. Thus, such a put option embedded in a publicly traded equity instrument to which it relates shall be separated from the host contract by the holder of the equity instrument if the criteria in paragraph 815-15-25-1(b) through (c) are also met. That put option also shall be separated from the host contract by the issuer of the equity instrument except in those circumstances in which the put option is not considered to be a derivative instrument pursuant to paragraph 815-10-15-74(a) because it is classified in stockholders’ equity. A purchased call option that enables the issuer of an equity instrument (such as common stock) to reacquire that equity instrument would not be considered to be a derivative instrument by the issuer of the equity instrument pursuant to that paragraph. Thus, if the call option were embedded in the related equity instrument, it would not be separated from the host contract by the issuer. However, for the holder of the related equity instrument, the embedded written call option would not be considered to be clearly and closely related to the equity instrument, if the criteria in paragraph 815-15-25-1(b) through (c) were met, and shall be separated from the host contract.

Put and call options are not considered clearly and closely related to an equity host contract because the economic risks and characteristics of redemption features are not the same as the economic risks and characteristics of an equity instrument. In determining whether a put or call option is considered clearly and closely related to an equity host, an entity should consider the payoff profile of the settlement (see Section 4.2.2) rather than whether the redemption is settled in cash or shares.

For example, a share-settled redemption that results in the delivery of a variable number of shares on the basis of a fixed value would be evaluated as a redemption feature (and not as a conversion feature). A share-settled redemption feature would not be considered clearly and closely related to an equity host contract, even though the contract is settled by delivery of the entity’s equity shares. Since the share-settled redemption would be based on a fixed monetary value payable in a variable number of shares, the economic risks and characteristics of such feature does not expose the holder to the variability of the underlying equity. Inversely, a cash conversion feature would typically be considered clearly and closely related to an equity host because the conversion value exposes the holder to similar risks and characteristics as those of an equity holder.

6.5.4 Derivative Analysis

ASC 815-10

15-107 The potential settlement of the debtor’s obligation to the creditor that would occur upon exercise of a put option or call option embedded in a debt instrument meets the net settlement criterion as discussed beginning in paragraph 815-10-15-100 because neither party is required to deliver an asset that is associated with the underlying. Specifically:

The debtor does not receive an asset when it settles the debt obligation in conjunction with exercise of the put option or call option.
The creditor does not receive an asset associated with the underlying.

15-109 The guidance in paragraph 815-10-15-107 shall not be applied under either of the following circumstances:

To put or call options that are added to a debt instrument by a third party contemporaneously with or after the issuance of a debt instrument. (In that circumstance, see paragraph 815-10-15-6.)
By analogy to an embedded put or call option in a hybrid instrument that does not contain a debt host contract.

As outlined in ASC 815-10-15-107 and ASC 815-10-15-109, it would be inappropriate to analogize the guidance on net settlement of a “debtor’s obligation to the creditor that would occur upon exercise of a put option or call option embedded in a debt instrument” to “a hybrid instrument that does not contain a debt host.”

The table below presents an analysis of whether a redemption feature embedded in an equity host contract meets the definition of a derivative. However, an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 1.4.1)	Yes	A redemption feature has both an underlying (the fair value of the shares to be redeemed) and a notional amount (the number of shares to be redeemed) or payment provision.
Initial net investment (see Section 1.4.2)	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 redemption feature on a stand-alone basis without the host contract). Generally, a redemption feature has an initial net investment that is smaller than would be required for a direct investment that pays the redemption amount (since the investment in the equity host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 1.4.3)	It depends	Typically, the entity would evaluate whether the equity contract is RCC (see below).

As presented in the table above, the determination of whether a redemption feature meets the definition of a derivative is generally focused on the net settlement characteristic.

Importantly, as noted in ASC 815-10-15-109, redemption features embedded in equity host contracts do not inherently meet the net settlement criterion since the issuer is delivering assets associated with an underlying. Whether the redemption feature meets the net settlement characteristic in the definition of a derivative generally depends on whether the hybrid contract qualifies as RCC. A publicly traded equity instrument that may be sold in increments that can be rapidly absorbed by the market without significantly affecting the price would be RCC. By contrast, equity shares of a private company that are not publicly traded would not be considered RCC, and the redemption feature would typically not meet the definition of a derivative. (See Section 1.4.3 for further discussion of how to determine whether an instrument is RCC.)

Example 6-9

Redemption Feature in a Preferred Stock Agreement

Company ABC issues convertible preferred stock, which is not publicly traded, to investors. The convertible preferred stock contains a provision that allows holders to redeem the preferred stock for cash in the event of a deemed liquidation event, which is defined in the underlying agreement as “a sale, merger, acquisition, or change in control” of ABC. Upon the occurrence of a deemed liquidation event, the preferred stockholders are entitled to be paid out of the assets of ABC that are available for distribution to its stockholders an amount per share equal to the applicable original issuance price, plus any dividends declared but unpaid (the “deemed liquidation contingent redemption feature”).

In determining whether the deemed liquidation contingent redemption feature requires bifurcation from the host contract, ABC considers the guidance in ASC 815-15-25-1. Because the redemption of an equity instrument for cash is not considered clearly and closely related to the host contract and the convertible preferred stock is not a hybrid instrument remeasured at fair value, ABC considers whether the deemed liquidation contingent redemption feature meets the definition of a derivative in accordance with ASC 815-10-15-83.

The settlement of the deemed liquidation contingent redemption feature requires the gross exchange of the preferred stock (which is not RCC since it is not publicly traded) in return for cash or other assets. In other words, the deemed liquidation contingent redemption feature does not allow for net settlement, and the net settlement criterion in the definition of a derivative is not met. (As noted in ASC 815-10-15-109, redemption features embedded in equity host contracts do not inherently meet net settlement.) Because the deemed liquidation contingent redemption feature would not meet the definition of a derivative if it were freestanding, the embedded feature should not be bifurcated from the host contract.

Example 6-10

Evaluating Whether a Share-Settlement Feature Embedded in an Equity Host Requires Bifurcation

Assume the same facts as in Example 6-4, in which the terms of the preferred stock provide for “conversion” into Tech Co.’s common stock upon a qualified equity financing at a price equal to 85 percent of the per-share price of common stock in the qualified equity offering. Since the preferred stock in this example contains an equity host, the determination of whether the issuer would be required to bifurcate this feature would typically focus on whether the net settlement criterion of the definition of a derivative is met.

Importantly, as noted in ASC 815-10-15-109, redemption features embedded in equity host contracts do not inherently meet the net settlement criterion since the issuer is delivering assets associated with an underlying. Whether the redemption feature would meet the net settlement criterion generally depends on whether the preferred stock qualifies as RCC. A publicly traded equity instrument that may be sold in increments that can be rapidly absorbed by the market without significantly affecting the price would be RCC. By contrast, equity shares of a private company that are not publicly traded would not be considered RCC, and the share-settled redemption feature would typically not meet the definition of a derivative. (See Section 1.4.3 for further discussion of how to determine whether an instrument is RCC.)

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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.