4.2 Step 1: Evaluate Any Exercise Contingencies

4.2.1 The Concept of an Exercise Contingency

ASC 815-40 — Glossary

Exercise Contingency

A provision that entitles the entity (or the counterparty) to exercise an equity-linked financial instrument (or embedded feature) based on changes in an underlying, including the occurrence (or nonoccurrence) of a specified event. Provisions that accelerate the timing of the entity’s (or the counterparty’s) ability to exercise an instrument and provisions that extend the length of time that an instrument is exercisable are examples of exercise contingencies.

Underlying

A specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable (including the occurrence or nonoccurrence of a specified event such as a scheduled payment under a contract). An underlying may be a price or rate of an asset or liability but is not the asset or liability itself. An underlying is a variable that, along with either a notional amount or a payment provision, determines the settlement of a derivative instrument.

Step 1 of the guidance in ASC 815-40-15-7 on the determination of whether an equity-linked instrument is considered indexed to an entity’s own equity is to evaluate the instrument’s exercise contingencies, if any. The following provisions are examples of exercise contingencies:

Type	Description	Examples
Exercise condition	A provision that affects whether the instrument becomes exercisable.	A warrant that becomes exercisable upon an IPO.
Settlement condition	A provision that affects whether an instrument is settled.	An obligation to issue shares that is contingent on whether revenue has exceeded a specified threshold.
Acceleration provision	A provision that accelerates the timing of either the entity’s or the counterparty’s ability to exercise the instrument or that accelerates the timing of the instrument’s settlement.	The counterparty’s right to exercise the instrument is accelerated upon a merger event, tender offer, hedging disruption, loss of stock borrow, nationalization, or delisting.
Extension provision	A provision that extends the timing of either the entity’s or the counterparty’s ability to exercise the instrument or extends the timing of the instrument’s settlement.	A provision that extends the expiration date of an option upon an IPO.
Deferral provision	A provision that defers the timing of either the entity’s or the counterparty’s ability to exercise the instrument or defers the timing of the instrument’s settlement.	A provision that delays the counterparty’s ability to exercise an option if the entity lacks sufficient registered shares or that defers settlement if the counterparty’s ownership of shares exceeds a specified level or the counterparty needs time to unwind related hedges.
Termination provision	A provision that results in the instrument’s termination (also sometimes called “cancellation,” “forfeiture,” or “knock-out” provision).	A provision that terminates the instrument upon a change of control, IPO, or insolvency.

Some, but not all, equity-linked instruments contain exercise contingencies. Step 1 does not apply to an equity-linked instrument that does not contain an exercise contingency (e.g., an option contract that is exercisable at any time before expiration). The mere passage of time is not considered an exercise contingency; neither is a contingency that affects the calculation of the settlement amount of an instrument if the contingency does not alter the availability or timing of settlement (e.g., the occurrence of a specified event that affects the strike price of an equity-linked option that was currently exercisable).

4.2.2 Effect of Exercise Contingencies on the Classification of an Equity-Linked Instrument

ASC 815-40

15-7A An exercise contingency shall not preclude an instrument (or embedded feature) from being considered indexed to an entity’s own stock provided that it is not based on either of the following:

An observable market, other than the market for the issuer’s stock (if applicable)
An observable index, other than an index calculated or measured solely by reference to the issuer’s own operations (for example, sales revenue of the issuer; earnings before interest, taxes, depreciation, and amortization of the issuer; net income of the issuer; or total equity of the issuer).

If the evaluation of Step 1 (this paragraph) does not preclude an instrument from being considered indexed to the entity’s own stock, the analysis shall proceed to Step 2 (see paragraph 815-40-15-7C).

Exercise contingencies that are based on an observable market or an observable index preclude an equity-linked instrument from being considered indexed to an entity’s own equity unless they are based on either of the following:

“[T]he market for the issuer’s stock.”
“[A]n index calculated or measured solely by reference to the issuer’s own operations.”

Further, an exercise contingency that is based on something other than an observable market or observable index does not preclude equity classification.

Example 4-2

Exercise Contingency Analysis

Entity R issues to certain investors warrants that permit the investors to purchase R’s common shares at a fixed price if the common shares trade below $7 per share. (Entity R’s shares currently trade at $10 each.) If the share price does not drop below $7 before the warrants’ expiration date, the warrants will expire.

The warrants issued by R contain a contingent exercise provision because they cannot be exercised unless R’s common shares trade below $7. However, because the exercise contingency is based directly on the market price of R’s common shares, the warrants are not precluded from being considered indexed to R’s own equity.

Had the exercise contingency been based on the price of gold’s dropping below a certain point, however, the warrants would not have been considered indexed to R’s own equity because such a contingent exercise provision would have been based on “[a]n observable market, other than the market for the issuer’s stock.”

If a freestanding equity-linked instrument contains more than one exercise contingency, the instrument would not be considered indexed to the entity’s own stock unless all the contingencies are consistent with equity classification.

4.2.2.1 Exercise Contingencies Based on the Market for the Issuer’s Stock

If an equity-linked instrument can be exercised only if the issuer’s stock exceeds a specified price, that exercise contingency would not preclude the instrument from being considered indexed to the entity’s own equity. This is because the issuer’s stock price is considered to be based on the market for the issuer’s stock. The term “market for the issuer’s stock” includes not only the price of the entity’s common or preferred stock but also:

The stock price of a consolidated subsidiary that is a substantive entity (see Section 2.6.1).
The price of a convertible debt or equity security in the evaluation of whether an equity conversion option embedded in the convertible security qualifies as being indexed to the entity’s own equity.

Examples of exercise contingencies in convertible instruments that would be considered to be based on the market for the issuer’s stock include:

A provision that permits the instrument to be converted if the entity’s stock price exceeds a certain dollar amount (a market price trigger).
A provision that permits the instrument to be converted into the entity’s equity shares if the instrument trades for an amount that is less than a specified percentage (e.g., 98 percent) of its if-converted value (a parity provision).

4.2.2.2 Exercise Contingencies Based on the Issuer’s Operations

An exercise contingency based on an index calculated solely by reference to the issuer’s own operations (e.g., sales of at least $100 million) does not preclude a conclusion that the equity-linked instrument is indexed to the entity’s own equity. Similarly, an exercise contingency that is based on an index calculated solely by reference to the operations of a consolidated subsidiary that is a substantive entity would not preclude such a conclusion by analogy to ASC 815-40-15-3 (see Section 2.6.1).

Exercise contingencies that are based on other observable markets (e.g., an option that is exercisable only if the market price of gold exceeds a certain level) or observable indexes (e.g., an option that is exercisable only if the CPI or S&P 500 exceeds a certain level) cause the instrument to be considered not indexed to the entity’s own equity.

4.2.2.3 Interaction Between Steps 1 and 2

ASC 815-40

15-7B If an instrument’s strike price or the number of shares used to calculate the settlement amount would be adjusted upon the occurrence of an exercise contingency, the exercise contingency shall be evaluated under Step 1 (see the preceding paragraph) and the potential adjustment to the instrument’s settlement amount shall be evaluated under Step 2 (see the guidance beginning in [ASC 815-40-15-7C]).

An entity need not consider an instrument’s exercise contingency under step 2 in ASC 815-40-15-7 if the contingency does not affect the settlement terms. For example, the entity would not need to consider under step 2 an exercise contingency that affects only (1) the entity’s ability to exercise or settle the instrument or (2) the timing thereof. In addition, an exercise contingency that merely results in the instrument’s cancellation (i.e., it affects only whether the instrument becomes settleable on the basis of its otherwise applicable settlement terms) does not require evaluation under step 2. However, some exercise contingencies also affect an instrument’s settlement terms, in which case the exercise contingencies should be evaluated under both step 1 in ASC 815-40-15-7 and step 2. In other words, even if an exercise contingency is of a type that does not preclude equity classification under step 1, any associated adjustment to the settlement terms may preclude equity classification under step 2 (see Section 4.3.5.7 for an example).

4.2.3 Examples of Exercise Contingencies

4.2.3.1 Classification and Application of Indexation Guidance

The following table contains examples of exercise contingencies and indicates whether they would preclude an equity-linked instrument from being considered indexed to the entity’s own stock:

Exercise Contingencies That Do Not Preclude Equity Classification	Exercise Contingencies That Preclude Equity Classification
Stock price of the issuer. Stock price of a consolidated subsidiary that is a substantive entity. Revenue, net income, or EBITDA of the issuer. Net assets of the issuer. Revenue, net income, or EBITDA of a consolidated subsidiary that is a substantive entity. A change of control or merger involving the issuer. An IPO of the issuer. An exchange listing or filing of a registration statement by the issuer. Delisting of the issuer. An offering of additional securities by the issuer. A stock split or other dilutive event carried out by the issuer. Extraordinary dividends. The issuer’s settlement of another outstanding security of the issuer (e.g., pursuant to exercise of a call option by the issuer or a conversion by the investor). Cost of stock borrow on the entity’s stock (including loss of stock borrow and increased cost of stock borrow). Nationalization. Insolvency. Change in law (e.g., a change in law that makes it illegal to be a party to the contract). Hedging disruption or increased cost of hedging related to the entity’s shares. Counterparty’s level of ownership of the entity’s shares. Event of default. Market disruption event (e.g., extended closure of stock exchange). A parity provision (convertible instruments only).1 The credit rating of the issuer (convertible instruments only).2	Stock price of a third party. Delisting of the stock of a third party. Revenue, net income, or EBITDA of a third party. Stock market index (e.g., S&P 500). Commodity price (e.g., gold, natural gas, or oil). Foreign currency rate or index. Interest rate or index (e.g., LIBOR). CPI. The relation between the stock price of the issuer and a stock market index. The relation between (1) the issuer’s revenue, net income, or EBITDA and (2) the revenue, net income, or EBITDA of a competitor company.

Exercise Contingencies That Do Not Preclude Equity Classification

Exercise Contingencies That Preclude Equity Classification

Stock price of the issuer.
Stock price of a consolidated subsidiary that is a substantive entity.
Revenue, net income, or EBITDA of the issuer.
Net assets of the issuer.
Revenue, net income, or EBITDA of a consolidated subsidiary that is a substantive entity.
A change of control or merger involving the issuer.
An IPO of the issuer.
An exchange listing or filing of a registration statement by the issuer.
Delisting of the issuer.
An offering of additional securities by the issuer.
A stock split or other dilutive event carried out by the issuer.
Extraordinary dividends.
The issuer’s settlement of another outstanding security of the issuer (e.g., pursuant to exercise of a call option by the issuer or a conversion by the investor).
Cost of stock borrow on the entity’s stock (including loss of stock borrow and increased cost of stock borrow).
Nationalization.
Insolvency.
Change in law (e.g., a change in law that makes it illegal to be a party to the contract).
Hedging disruption or increased cost of hedging related to the entity’s shares.
Counterparty’s level of ownership of the entity’s shares.
Event of default.
Market disruption event (e.g., extended closure of stock exchange).
A parity provision (convertible instruments only).1
The credit rating of the issuer (convertible instruments only).2

Stock price of a third party.
Delisting of the stock of a third party.
Revenue, net income, or EBITDA of a third party.
Stock market index (e.g., S&P 500).
Commodity price (e.g., gold, natural gas, or oil).
Foreign currency rate or index.
Interest rate or index (e.g., LIBOR).
CPI.
The relation between the stock price of the issuer and a stock market index.
The relation between (1) the issuer’s revenue, net income, or EBITDA and (2) the revenue, net income, or EBITDA of a competitor company.

Examples 2 through 21 in ASC 815-40-55 (listed in Appendix A of this Roadmap) illustrate the application of the guidance in ASC 815-40-15-7. Five of the examples address how to apply step 1 of such guidance and involve the following exercise contingencies:

IPO (Examples 2 and 5).
Sales to third parties (Example 3).
Increase in S&P 500 (Example 4).
Market price trigger (Example 19).
Parity provision (Example 19).
Merger announcement (Example 19).

Examples 2, 3, and 4 are reproduced below. Examples 5 and 19 are addressed in our discussion of step 2 of the guidance (see Sections 4.3.5.6, 4.3.7.9, and 4.3.7.10).

ASC 815-40

Example 2: Variability Involving Completion of an Initial Public Offering

55-26 Entity A issues warrants that permit the holder to buy 100 shares of its common stock for $10 per share. The warrants have 10-year terms; however, they only become exercisable if Entity A completes an initial public offering. The warrants are considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The exercise contingency (that is, the initial public offering) is not an observable market or an observable index, so the evaluation of Step 1 does not preclude the warrants from being considered indexed to the entity’s own stock. Proceed to Step 2.
Upon exercise, the settlement amount would equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price ($10 per share).

Example 3: Variability Involving Sales Volume

55-27 Entity A issues warrants that permit the holder to buy 100 shares of its common stock for $10 per share. The warrants have 10-year terms; however, they only become exercisable after Entity A accumulates $100 million in sales to third parties. The warrants are considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The exercise contingency (that is, the accumulation of $100 million in sales to third parties) is an observable index. However, it can only be calculated or measured by reference to Entity A’s sales, so the evaluation of Step 1 does not preclude the warrants from being considered indexed to the entity’s own stock. Proceed to Step 2.
Step 2. Upon exercise, the settlement amount would equal the difference between the fair value of a fixed number of the entity’s equity shares (100 shares) and a fixed strike price ($10 per share).

Example 4: Variability Involving Stock Index

55-28 Entity A issues warrants that permit the holder to buy 100 shares of its common stock for $10 per share. The warrants have 10-year terms; however, they only become exercisable if the Standard & Poor’s S&P 500 Index increases 500 points within any given calendar year during that 10-year period. The warrants are not considered indexed to Entity A’s own stock based on the following evaluation:

Step 1. The exercise contingency (that is, the increase of 500 points in Standard & Poor’s S&P 500 Index) is based on an observable index that is not measured solely by reference to the issuer’s own operations.
Step 2. It is not necessary to evaluate Step 2.

4.2.3.2 Share-Settleable Earn-Out Arrangements

Share-settleable earn-out arrangements are entered into in conjunction with a merger of a SPAC and an operating entity (or “target”). They may also be entered into in conjunction with other transactions. For additional discussion of the nature of these arrangements, see Section 2.5.3.

If share-settleable earn-out arrangements contain only transfer restrictions that lapse upon the passage of time, they are not subject to an evaluation under ASC 815-40 because these types of arrangements are accounted for as outstanding shares as opposed to equity-linked instruments. All other share-settleable earn-out arrangements are considered equity-linked instruments that are subject to an evaluation under ASC 815-40 regardless of whether the underlying shares are legally outstanding.

After identifying each unit of account related to a share-settleable earn-out arrangement, the entity then evaluates the indexation requirements in ASC 815-40-15. If the entity determines that the equity-linked instrument is not considered indexed to the combined company’s stock, the arrangement must be classified as a liability (i.e., equity classification is never permitted). The first step in the analysis of the indexation guidance is to evaluate exercise contingencies.

All share-settleable earn-out arrangements contain contingent exercise provisions, and most also contain settlement provisions (i.e., terms or features that affect the settlement amount). In some cases, a provision may have characteristics of both contingent exercise and settlement provisions. The determination of whether the terms of a share-settleable earn-out arrangement are contingent exercise provisions or settlement provisions can significantly affect whether the equity-linked instrument is indexed to the combined company’s stock because the guidance on contingent exercise provisions is markedly different from the guidance on settlement conditions.

For example, assume that a share-settleable earn-out arrangement specifies that the combined company will issue an aggregate of 5 million shares of its common stock to the target’s shareholders if either (1) the quoted price of the stock exceeds $20 during a stated period or (2) there is a change of control. In this example, the combined company’s stock price and the occurrence of a change of control affects only whether the holders will receive the 5 million shares. Both variables represent only contingent exercise provisions because the holders will receive either no shares or 5 million shares. Neither of these two variables represents an exercise contingency that prevents the instrument from being indexed to the combined company’s stock under step 1 of ASC 815-40-15-7A. Note that the facts in this case are different from those in Example 2-3. In that example, the holders may receive no shares, 1 million shares, 2 million shares, 3 million shares, or 4 million shares, depending on the combined company’s stock price or the price paid in a change of control. In both examples, there are contingent exercise provisions (i.e., stock price and whether a change of control occurs); however, only in Example 2-3 are there settlement provisions because of the variability in the number of shares that will be issued.

For an exercise contingency not to prevent a share-settleable earn-out arrangement from being indexed to the combined company’s stock, it must meet the requirements in step 1 of ASC 815-40-15-7A. The terms of share-settleable earn-out arrangements that reflect contingent exercise provisions (e.g., the combined company’s stock price or a change of control) generally do not prevent the equity-linked instrument from meeting the conditions in the first step in the analysis in ASC 815-40-15 of whether the arrangement is considered indexed to the combined company’s stock. However, terms that affect the settlement value of the arrangement (i.e., settlement provisions) may prevent it from being indexed to the combined company’s stock under step 2 of ASC 815-40-15. See Sections 4.3.7 and 4.3.7.4 for additional discussion of the evaluation of settlement provisions in share-settleable earn-out arrangements.

Footnotes

An exercise contingency that is based on a parity provision or the credit rating of the issuer would generally be included only in the terms of a convertible instrument, not in those of a freestanding equity-linked instrument. If an exercise contingency that is based on a parity provision or the credit rating of the issuer was included in the terms of a freestanding equity-linked financial instrument, the exercise contingency would generally preclude the freestanding financial instrument from being indexed to the entity’s stock. See, however, Section 4.3.7.14.

See footnote 1.

Confidential and Proprietary — for Use Solely by Authorized Personnel

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.