Accounting for Stock Warrants

I have a corporate client with an interesting situation. They received funds from a private venture group that is funded by a government agency. The funds are to be used by my client to make various product development enhancements that are in the interest of this agency. My clients products are sold to this agency as well as many other customers.

As part of the deal, this venture group will receive stock warrants in the corporation. These warrants allow the venture group to receive stock in the corporation if the corporation stock reaches issues its stock to other outside investors at or above a certain price in the next 5 years. If the stock does not hit that price issuance never occurs, the venture group cannot exercise the warrant. If it does, then they can. The venture group does not have to pay any additional dollars to exercise the warrant at that time.

How do we account for the receipt of these funds? Is it income? Is it paid-in-capital? A little of both? Something else?

Edit 6/29/16: Original text has been stricken. Underlined text has been added.

I have no idea, but it might be covered in this PwC document, starting at page 8-3. https://www.pwc.com/us/en/cfodirect/ass ... n-2015.pdf

Just curious - do they get the stock (if it reaches the target price within 5 years) without further payment?

From a tax viewpoint, is this just warrants issued for the obtaining of the funds? http://www.thetaxadviser.com/issues/201 ... ic-10.html

Just curious - do they get the stock (if it reaches the target price within 5 years) without further payment?

Yes

From a tax viewpoint, is this just warrants issued for the obtaining of the funds?

I guess we can say that. My client received cash and they only thing they gave up were these warrants.

Maybe, that's not all they gave up. They also gave the promise that the funds would be used to make enhancements to a product that their customer purchases.

From the pwc document:

8.2.2.3 Warrants to participate in a future equity offering

A reporting entity may issue a warrant that allows the holder to purchase shares of the
reporting entity’s next issuance of preferred stock at the same price paid by other
investors in that preferred stock. A warrant to participate in a future equity offering is
typically issued to a debt or equity investor. The terms of the future issuance of
preferred stock are generally unknown and subject to negotiation with potential
investors. Absent a future preferred stock issuance, the warrant holder is not entitled
to exercise the warrant for any other consideration.

At issuance, these warrants are not a liability within the scope of ASC 480 because
they are within the reporting entity’s control to decide whether it will sell preferred
stock or not. Further, since the terms of any future preferred stock issuance have not
been determined, and when determined will generally be based upon market terms,
reporting entities generally do not recognize these contracts until the terms are
negotiated and the preferred shares are issued.

I am reading this as saying that the issuance of the warrants are neither a liability nor an equity. Doesn't that only leave the P&L as the recipient of the CR portion of the entry.

As to the accounting side, I have not read the PwC document very carefully. As to the tax side, let's hold off until we, or at least I, know the facts better.

Just looking at the economics, it is necessary to be clear on each piece of this. A private entity funded by a gov't. agency is confusing to me. Did a gov't. agency invest the money to be used as you describe, upon recommendation of the private entity, or did the private entity get money from the gov't. to invest as it decided? Did the private entity get a note or stock as well, or only the warrants? If no note and no stock were issued and the investment was made by the private entity (using gov't. funds, I take it), then it appears to me that in essence the private entity paid $X for warrants, end of story. Therefore, your client received that same amount for issuing warrants.

Take a look at sections 118 and 362 and see if they seem to come close to your facts.

Just looking at the economics, it is necessary to be clear on each piece of this. A private entity funded by a gov't. agency is confusing to me. Did a gov't. agency invest the money to be used as you describe, upon recommendation of the private entity, or did the private entity get money from the gov't. to invest as it decided?
The latter. The private entity is In-Q-Tel. You can read about them here: https://www.iqt.org/about-iqt/

Did the private entity get a note or stock as well, or only the warrants? If no note and no stock were issued and the investment was made by the private entity (using gov't. funds, I take it), then it appears to me that in essence the private entity paid $X for warrants, end of story. Therefore, your client received that same amount for issuing warrants.
They only received the warrants.

Take a look at sections 118 and 362 and see if they seem to come close to your facts.
Sections 118 & 362 of what?

I forget. It may have been Title 26 of the U. S. Code.

Ah! I thought we were holding off on the tax side for now. §118(b) is interesting - I guess a customer cannot make a capital contribution.

Speaking of 'tax side'... Did I mention this was an S-Corp? If this influx of cash is considered capital, is there a 2nd class of stock issue here?

You keep adding facts.

Reg. 1.1361-1(i) is the one that discusses in detail what is a second class of stock.

My main point about 118 and 362 is that no tax basis is created when a non-shareholder contributes capital. Your facts add the (to me) confusing aspect that the money came indirectly from a gov't. agency but directly from a private entity.

When there is a cost to raise capital (in this case the value of the warrants), that cost is not deductible. It is simply a cost of raising capital. In your facts, the value of the warrants is very hard to ascertain.

In my experience, warrants are options to purchase stock at a stated price. In your case, they seem to be at a price of zero but can be exercised only if and when the issuance that you describe occurs.

This discussion should keep going and should be on the Tax Forum.

https://www.irs.gov/pub/irs-wd/1232007.pdf

http://smallbusiness.chron.com/can-s-co ... 65096.html

Leonard, I am sorry. I only added the fact about it being an S-Corp because you started talking tax. This is still a GAAP accounting question.

BTW, thank you for the two tax-related links. Great info!

What is your GAAP conclusion?

I have none.

Back at Post #6, I referenced a section of that PwC document. In that document, it talks about warrants being issued along with another financial transaction such as a loan or a separate equity investment. And if these warrants are not able to be valued and uncertainty exists as to whether they will ever materialize, then no part of the transaction should be assigned to the warrants. They are ignored.

That makes sense if there is another financial transaction. The problem here is what is the 'other' financial transaction?

Let's take the warrants away from the discussion. Let's say In-Q-Tel makes this 'investment' into my client with no strings attached other than the desire that my client use it to make improvements to their products. These products are then sold to a government agency that provided these funds to In-Q-Tel.

Can we collapse this government agency & In-Q-Tel into one entity and call them my client's customer? What would it be if your customer gave you money and all you gave back to them is the promise to use that money to make your products better? Is that a 'gift' aka capital? Can you get a gift from your customer? Is it revenue?

Maybe tail wagging dog. Need to look at GAAP for the part of the transaction that gives them funds to spend as you describe. I jumped to the warrants.

It does not seem to be income if there is an obligation to spend it a certain way. I'd look into calling it deferred liability, and amortize it against the expenses for which it is used, and throw in a clear explanatory footnote.

This is primarily but not solely for non-profits, but it's a start. http://www.fasb.org/resources/ccurl/770/425/fas116.pdf

Also look at http://www.iasplus.com/en/standards/ifric/ifric18

I'm in over my head. But I do not see it as income.

Thanks, Leonard. I appreciate the back and forth.