Classifying as Debt vs. Equity to Raise Capital
By Bill Beiermeister
It can be tempting to use financial instruments to quickly raise cash, especially for technology and life sciences companies that must go through several rounds of financing before they can develop marketable product lines and begin generating income.
But if you’re thinking about going this route, tread carefully. Some financial instruments must be treated as liabilities on your balance sheet if payment is demanded at certain times or under stated circumstances. Prospective company buyers can see these liability agreements as a drag on the balance sheet.
The classification can also have a significant impact on earnings and financial position, as GAAP accounting regulations require liabilities to be measured at fair value at each reporting period.
Begin by analyzing and summarizing the terms of the agreement and other relevant documents to determine the proper classification. Some are easily classified such as common stock and bonds. These three categories of financial instruments are required to be accounted for as liabilities and may be challenging in determining their classification
- Mandatory redeemable shares
- Shares that obligate the issuer to buy back some of its shares under certain circumstances
- Any obligation that must be settled with a variable number of shares under certain conditions
Preferred stocks, convertible debt and warrants could be classified either way, depending on how terms are arranged. But in general, if the date and amount to be paid are fixed, the transaction must be treated as a liability.
Consult your advisers
There can be a lot of grey area in whether a financial instrument creates a liability, and it is up to you to be on top of this issue. Discuss any potential moves in detail with your financial advisers, and make sure you understand the full ramifications of any financing instruments before drafting documents.
As a manager with Wiss & Company’s Middle Market Commercial practice group, Bill Beiermeister, CPA, works predominately with tech and life sciences companies in New York City.