Tranched preferred stock combines a current issuance of preferred stock with rights to buy additional shares in the future. This type of financing technique is useful when there is an immediate need for cash as well as a future need. Tranched preferred stock is common in biotech and technology industries with multiple technical or regulatory milestones. The future tranche is usually timed to coincide with an expected future need for capital based on the entity’s product roadmap. Tranched preferred stock allows the investor to defer a portion of the cash funding until a future date and aligns funding with the entity’s performance. From the entity’s perspective, the tranched preferred stock reduces future fundraising risk.

The future tranche is contractually agreed to at the initial closing date and results in preferred shares being issued upon the occurrence of a milestone or future event, or on a specified future date. Depending on how the agreement is structured, the future tranche issuance may be automatic, optional to the issuer, optional to the investor, or contingent on other factors.

Determining whether the future tranche commitment is a freestanding financial instrument

Because the future tranche commitment is issued with the initial preferred stock issuance, the first step is to determine whether it is a freestanding financial instrument or a component embedded in the preferred stock.

ASC 480 defines a freestanding financial instrument as one that is entered into in conjunction with some other transaction and is both: 1) legally detachable and 2) separately exercisable.

If the initial preferred shares or the future tranche commitment can be transferred separately to another party and the initial preferred shares remain outstanding when the future tranche commitment is exercised, the instruments would be freestanding. While the agreement may prohibit any transfer of the future tranches separate from the preferred shares, if the holders have the right to convert those preferred shares into common stock at any time and the holder is not restricted from selling those common shares, this indicates the future tranche commitments are legally detachable from the preferred shares.

However, if the future tranche commitment cannot be transferred without the initial preferred shares, and the initial preferred shares remain outstanding upon exercise or fulfillment of the future tranche commitment, the instruments are not freestanding. They are an embedded feature of the preferred shares.

Accounting for future tranche commitment when it is a freestanding financial instrument

If the future tranche commitment is a freestanding instrument, the first step is to determine its proper classification. The classification determines how to allocate the proceeds between the freestanding future tranche commitment and the preferred shares issued.

First, evaluate the future tranche commitment to determine whether it falls within the scope of ASC 480.

The following categories are required to be accounted for as liabilities under ASC 480:

• Shares that are mandatorily redeemable
• Financial instruments other than a share that represent or are indexed to obligations to repurchase the issuer’s equity shares by transferring assets
• Certain obligations to issue a variable number of shares

In addition, ASC 480 requires liability classification for an instrument that embodies, or is indexed to, a conditional or unconditional obligation to repurchase the issuer’s equity shares that require or could require settlement by the transfer of assets. This applies if the underlying equity shares contain a redemption requirement that is not solely within the Company’s control. If the preferred shares are redeemable upon a written request from the holders, they are essentially a forward sale contract on redeemable equity securities. They should be classified as a liability under ASC 480. If it is a liability under ASC 480, the future tranche commitment would be recorded as a liability initially at fair value, with changes in fair value recorded in earnings.

If the future tranche commitment is not within the scope of ASC 480, it should be evaluated using the model for freestanding equity-linked instruments under ASC 815-40 to determine if it is (1) an equity instrument or (2) a liability.

If the future tranche commitment meets the criteria to be classified as equity under ASC 815-40, the proceeds from the original issuance should be allocated to the originally issued preferred stock and the future tranche commitment using the relative fair value method. If the commitment is classified as equity, it should not be remeasured subsequently.

If the future tranche commitment does not meet the criteria to be classified as equity, classify it as a liability at fair value. The proceeds from the original issuance should be allocated first to the future tranche commitment at fair value, with any remainder allocated to the originally issued preferred stock. Subsequently, record the future tranche commitment initially at fair value, with changes in fair value recorded in the income statement.

Accounting for future tranche commitment when it is an embedded feature

If the future tranche commitment is a feature embedded in the issued preferred share, the embedded feature will need to be analyzed under ASC 815-15 to determine whether it should be bifurcated. First, analyze the host instrument to determine whether it is a debt or equity host.

Pursuant to ASC 815, the embedded feature is bifurcated from the host contract and accounted for as a derivative instrument if all the following criteria are met:

• The economic characteristics and risks of the embedded derivative are not “clearly and closely related” to the economic characteristics and risks of the host contract.
• The contract that embodies both the embedded derivative and the host contract is not remeasured at fair value under otherwise applicable US GAAP with changes in fair value reported in earnings as they occur.
• A separate, freestanding instrument with the same terms as the embedded derivative would be a derivative instrument subject to ASC 815.

If the embedded features are not clearly and closely related to the equity host, evaluate whether the future tranche commitment meets the definition of a derivative. ASC 815 defines a derivative instrument as a financial instrument or other contract with all of the following characteristics:

1. Underlying, notional amount payment provision
2. Initial net investment
3. Net settlement

Often, the entities issuing tranched preferred shares are not publicly traded. Therefore, the future tranche commitment does not meet the definition of a derivative because it is not net settleable, as the underlying shares are not readily convertible to cash. In such situations, the embedded future tranche commitment would not be bifurcated and would not be accounted for separately.

If the embedded future tranche commitment meets the definition of a derivative, it would be evaluated for the ASC 815 exception from derivative accounting. If it does not meet the scope exception, then the future tranche commitment would be recorded as a liability initially at fair value, with changes in fair value recorded in earnings.