B.4 Examples
B.4.1 Distributions From the Proceeds of an Offering
Example B-1
Assume the following:
- Company A, a calendar-year-end entity, plans to complete an IPO in June 20X9.
- Before its IPO, A had 5,000 shares of common stock outstanding.
- In the IPO, A expects to issue 1 million shares of common stock at an expected offering price of $100 per share.
- For the year ended December 31, 20X8, A has net income of $100,000.
- On December 31, 20X8, A declares a dividend of $1,000 per share to its owners (i.e., a total dividend of $5 million). No other dividends are paid or declared in 20X8.
Because the dividends for 20X8 exceed A’s net income for this year, the SEC
staff would consider the dividend payments to have been
made in contemplation of A’s planned IPO. Accordingly,
in the Form S-1 filing for its IPO, A should present pro
forma EPS outside the financial statements for the year
ended December 31, 20X8, and for the three months ended
March 31, 20X9, that reflects an additional 49,000
common shares in the denominator of both basic and
diluted EPS.
The incremental number of shares of common stock included in the denominator is calculated as follows:
Since the 49,000 incremental common shares required for the pro forma EPS disclosure do not exceed the common shares being offered in the IPO, all of the incremental shares should be included in the calculation of pro forma EPS.
B.4.2 Change in Capitalization at or Before Closing of an IPO
Example B-2
Assume the following:
- Company B, a calendar-year-end entity, plans to complete an IPO in March 20X5. The latest financial statements included in the Form S-1 registration statement are as of and for the year ended December 31, 20X4.
- Company B has the following outstanding securities:
- 100,000 shares of common stock.
- 100,000 shares of participating convertible preferred stock that are automatically converted into common shares upon the occurrence of an IPO (the “preferred shares”). The aggregate liquidation preference of the preferred shares is $1 million. Each preferred share is convertible into one share of common stock. The preferred shares receive dividends, on a cumulative basis, at an annual rate of 8 percent (or $80,000 per annum). In addition, after such payments, the holders are entitled to participate in dividends with common shareholders on a 35:65 basis and such participation is determined on the basis of the number of shares of common stock issuable on conversion of the preferred shares.
- Options that allow the holders to purchase 50,000 shares of common stock that are not automatically exercised upon the occurrence of an IPO. The options do not represent participating securities.
- For the year ended December 31, 20X4:
- Company B reports net income of $500,000.
- No dividends are paid or declared on common stock.
- Under the treasury stock method, the options result in 25,000 incremental shares.
Company B’s calculation of EPS for the year ended December 31, 20X4, is as follows:
Basic EPS:
Diluted EPS:
Diluted EPS is presented under the if-converted method since it is more dilutive than the two-class method of calculating diluted EPS.
(a) Two-class method:
(b) If-converted method:
Company B calculates pro forma EPS for the year ended December 31, 20X4, which
would be presented outside the financial statements, as
follows:
Pro Forma Basic EPS:
Pro Forma Diluted EPS:
Note that diluted pro forma EPS is not calculated under the two-class method because, after the conversion of the preferred shares, there are no remaining participating securities.
B.4.3 Use of Proceeds From Offering of Convertible Securities to Extinguish Preferred Stock or Debt
Example B-3
Assume the following:
- Company C is offering $500 million of convertible preferred stock (the “preferred stock”).
- The “use of proceeds” section in the registration statement for the offering states that the proceeds from issuance of the preferred stock will be used to redeem C’s outstanding senior secured notes (the “notes”) and for general corporate purposes.
- Key terms and characteristics of the notes include:
- The notes are not convertible into common stock.
- The notes are not participating securities.
- The notes are accounted for at amortized cost.
- The current amortized cost of the notes is $245 million.
- The outstanding principal amount of the notes is $250 million.
- The notes do not contain any embedded derivatives that must be accounted for separately.
- The notes contain an embedded call option that allows C to redeem them at any time for the principal amount plus a make-whole premium. The current redemption amount is $260 million. Therefore, the redemption will result in a pretax extinguishment loss of $15 million or $12 million, net of tax.
- The notes are outstanding during the entire year ended December 31, 20X1.
- Interest expense on the notes during the year ended December 31, 20X1, net of tax, is $9 million.
- Key terms and characteristics of the preferred stock include:
- The conversion option in the preferred stock must be settled in common stock.
- Upon full conversion, C would be required to issue 8 million shares of common stock.
- The conversion option in the preferred stock is not “in-the-money” as of the issuance date.
- The preferred stock is not a participating security.
- Dividends on the preferred stock, which are cumulative and not tax-deductible, accrue at a rate of 3.5 percent per annum.
- The preferred stock will be classified in permanent equity.
- The preferred stock will not contain any embedded derivatives that must be accounted for separately.
- Before the offering, C’s capital structure consists solely of the notes, common stock, and options to purchase common stock, which are not participating securities. For the year ended December 31, 20X1, on a weighted-average basis, C has 10 million shares of common stock outstanding and 1 million incremental potential common shares, as calculated under the treasury stock method.
- Company C reports net income of $50 million for the year ended December 31, 20X1.
Company C presents basic and diluted EPS for the year ended December 31, 20X1, as follows:
Basic EPS:
Diluted EPS:
The adjustments to C’s historical basic and diluted EPS to arrive at pro forma basic and diluted EPS for the year ended December 31, 20X1, are as follows:
EPS | Nature of Pro Forma Adjustments |
|---|---|
Basic | Numerator:
The numerator in the historical calculation of
basic EPS should be decreased by $12.1 million,
calculated as the $12 million loss on
extinguishment of the notes, net of tax, plus the
$100,000 difference between interest on the notes
and dividends on the preferred stock, which is
calculated as follows: Denominator: There are no adjustments to the denominator in the historical calculation of basic EPS. |
Diluted | Numerator: The numerator in the historical calculation of diluted EPS should be decreased
by $3 million, representing the $12 million loss
on the extinguishment of debt, net of tax, less
the add-back of $9 million of interest on the
notes, net of tax. The dividends on the preferred
stock do not affect the numerator for pro forma
diluted EPS because the preferred stock is
dilutive under the if-converted method. Denominator: The denominator in the historical calculation of diluted EPS should be increased
by 4.16 million shares of common stock,
representing the number of shares of common stock
to be issued from the application of the
if-converted method to $260 million of preferred
stock (i.e., 8 million common shares issuable upon
full conversion × [$260 million ÷ $500 million]).
No additional adjustments are necessary since the
notes are not convertible into common stock. |
The calculation of pro forma basic and diluted EPS for
the year ended December 31, 20X1, which would be
presented outside the financial statements, is as
follows:
Pro Forma Basic EPS:
Pro Forma Diluted EPS:
Example B-4
Assume the following:
- Company D is offering 100 million common shares (the “common stock”) and detachable warrants to purchase 100 million common shares (the “warrants”). On the basis of the offering prices, D expects to raise $900 million.
- The “use of proceeds” section in the registration statement for the offering states that the proceeds from issuance of common stock and warrants will be used to redeem all of D’s outstanding senior secured debentures (the “debentures”) and an amount of outstanding convertible preferred stock (the “preferred stock”) that is tendered by the holders in accordance with the terms of a tender offer but not to exceed $500 million. Company D expects that the tender offer will result in the repurchase of half of the outstanding preferred stock for $500 million. The anticipated purchase price is equal to the carrying amount of the preferred stock to be redeemed.
- Key terms and characteristics of the debentures include:
- The debentures are not convertible into common stock.
- The debentures are not participating securities.
- The debentures are accounted for at amortized cost.
- The current amortized cost of the debentures is $400 million.
- The outstanding principal amount of the debentures is $400 million.
- The debentures do not contain any embedded derivatives that must be accounted for separately.
- The debentures contain an embedded call option that allows D to redeem them at any time after December 31, 20X2, at the outstanding principal amount.
- The debentures were outstanding during the entire year ended December 31, 20X2.
- Interest expense on the debentures during the year ended December 31, 20X2, net of tax, was $18 million.
- Key terms and characteristics of the preferred stock include:
- The conversion option in the preferred stock must be settled in common stock.
- Upon full conversion, D would be required to issue 50 million shares of common stock.
- The preferred stock is not in-the-money on the issuance date.
- The preferred stock is not a participating security.
- Dividends on the preferred stock, which are cumulative and not tax-deductible, accrue at a rate of 6 percent per annum.
- The preferred stock is classified in permanent equity.
- The preferred stock does not contain any embedded derivatives that must be accounted for separately.
- The aggregate liquidation preference of the preferred stock is $1 billion.
- The preferred stock is outstanding during the entire year ended December 31, 20X2.
- Key terms and characteristics of the warrants include:
- The warrants are not participating securities.
- The exercise price of the warrants will be set at a 35 percent premium to the market price of D’s common stock.
- At no point during the year ended December 31, 20X2, did the fair value of D’s common stock exceed the exercise price of the warrants.
- Before the offering, D’s capital structure consists solely of the debentures, preferred stock, common stock, and options to purchase common stock, which are not participating securities. For the year ended December 31, 20X2, on a weighted-average basis, D has 300 million shares of common stock outstanding and 10 million incremental potential common shares related to the options to purchase common stock, as calculated under the treasury stock method.
- Company D reports net income of $500 million for the year ended December 31, 20X2.
Company D presents basic and diluted EPS for the year ended December 31, 20X2, as follows:
Basic EPS:
Diluted EPS:
The adjustments that D makes to its historical basic and diluted EPS to arrive at pro forma basic and diluted EPS for the year ended December 31, 20X2, are as follows:
EPS | Nature of Pro Forma Adjustments |
|---|---|
Basic | Numerator: The numerator in the historical calculation of basic EPS should be increased by
$48 million, calculated as follows: Denominator: The denominator in the historical calculation of basic EPS should be increased by 100 million for the common shares to be issued in the offering. Note that the issuance of the warrants does not affect the calculation of pro forma basic EPS since the warrants do not represent participating securities. |
Diluted | Numerator: The numerator in the historical calculation of diluted EPS should be increased by $18 million, representing the add-back of interest, net of tax, on the notes. No adjustment is needed for dividends on the preferred stock because the numerator in the historical calculation of diluted EPS included an add-back for such dividends under the if-converted method. Denominator: The denominator in the historical calculation of diluted EPS should be increased by
75 million shares of common stock, calculated as follows: There is no incremental dilutive impact of the warrants to be issued in the offering because they are out-of-the-money. |
The calculation of pro forma basic and diluted EPS for
the year ended December 31, 20X2, which would be
presented outside the financial statements, is as
follows:
Pro Forma Basic EPS:
Pro Forma Diluted EPS:
Example B-5
Assume the following:
- Company E is offering $500 million of convertible notes (the “notes”).
- The “use of proceeds” section in the registration statement for the offering states that the proceeds from issuance of the notes will be used to retire E’s outstanding preferred stock (the “preferred stock”).
- Key terms and characteristics of the preferred stock include:
- There are 500,000 shares of preferred stock outstanding.
- Each share of preferred stock has a liquidation preference of $1,000 per share.
- The preferred stock is not convertible.
- Dividends on the preferred stock, which are cumulative and not tax-deductible, accrue at a rate of 6 percent per annum. The preferred stock also participates in dividends declared on E’s common stock on a 1:1 basis, calculated on the basis of the number of shares outstanding.
- The preferred stock is classified in permanent equity.
- The preferred stock does not contain any embedded derivatives that must be accounted for separately.
- Company E has a call option that allows it to redeem the preferred stock for $500 million.
- The preferred stock is recorded at $500 million on E’s balance sheet.
- The preferred stock is outstanding during the entire year ended December 31, 20X2.
- Key terms and characteristics of the notes include:
- The notes are convertible into common stock at a conversion rate of 50 shares for each 1,000 principal amount (or 25 million shares of common stock upon full conversion).
- The notes bear interest at an annual rate of 3.375 percent. Interest on the notes is tax-deductible (assume a 20 percent tax rate).
- The notes also participate in dividends paid on common stock on an as-converted basis.
- The notes will be accounted for at amortized cost.
- The notes will not contain any embedded derivative that must be accounted for separately.
- Before the offering, E’s capital structure consists solely of the preferred stock, common stock, and options to purchase common stock, which are not participating securities. For the year ended December 31, 20X2, on a weighted-average basis, E has 150 million shares of common stock outstanding and 5 million incremental potential common shares related to the options to purchase common stock, as calculated under the treasury stock method.
- Company E reports net income of $250 million for the year ended December 31, 20X2.
- Company E does not declare any dividends on common stock during the year ended December 31, 20X2.
- Company E is subject to the two-class method because the preferred stock is a participating security.
Company E presents basic and diluted EPS for the year ended December 31, 20X2, as follows:
Basic EPS:
Diluted EPS:
The adjustments that E makes to its historical basic and diluted EPS to arrive at pro forma basic and diluted EPS for the year ended December 31, 20X2, are as follows:
EPS | Nature of Pro Forma Adjustments |
|---|---|
Basic | Numerator: The numerator in the historical calculation of basic EPS should be decreased by $16,554,817, calculated as follows: The extinguishment of the preferred stock will
not result in an adjustment to retained earnings
because the redemption amount and the carrying
amount of the preferred stock are the same;
therefore, no adjustment is necessary for the
extinguishment on the basis of the facts in this
example. Denominator: There are no adjustments to the denominator in the historical calculation of basic EPS. |
Diluted | Numerator: The numerator in the historical calculation of diluted EPS should be decreased by $15,639,827, calculated as follows: Denominator: There are no adjustments to the denominator in the historical calculation of diluted EPS because EPS is more dilutive under the two-class method than under the if-converted method. |
The calculation of pro forma basic and diluted EPS for the year ended December
31, 20X2, which would be presented outside the financial
statements, is as follows:
Pro Forma Basic EPS:
Pro Forma Diluted EPS:
Pro forma diluted EPS is presented under the two-class method since it is more dilutive than the if-converted method.
(a) Two-class method:
(b) If-converted method: