Capital Markets

FASB Change Could Help PIPEs Flow

This week, FASB will change an accounting policy that some small firms consider onerous to raising capital.
Helen ShawOctober 18, 2006

An accounting policy that some say has made it more difficult for smaller public companies to raise capital through private investment in public equity (PIPE) transactions is about to change.

Under EITF 00-19, “Accounting for Derivative Financial Instruments Indexed To, and Potentially Settled In, a Company’s Own Stock,” guidance from the Financial Accounting Standards Board’s Emerging Issues Task Force, there are two issues that affect PIPE transactions.

In a PIPE deal, a public company often issues unregistered equity-linked securities to a group of private investors at a discount to the price of the issuer’s common stock at the time the deal is closed. The deals include a registration rights agreement, in which the company commits to register the securities with the Securities and Exchange Commission so they can be resold to the public, usually within 90 to 120 days.

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Under the agreement, if the registration statement isn’t effective by a certain time, then the firm must pay liquidated damages — cash — to investors. However, this place the firm at the mercy of the SEC and auditors, who both have the power to decide whether the registration statement is effective. That can create significant liability for the firm the statement is not accepted — or even if there is a delay. Liquidated damages, also called the registration payment, typically can be one to two percent of the amount invested for every 30 days of a delay, observes John Hogoboom, an attorney at Lowenstein Sandler.

And there is another issue – companies account for the cash payments differently. Some believe the inclusion of the registration payment in the agreement makes it a liability; others disagree and treat it as equity.

Under the current EITF, firms that consider the payment a liability don’t have the freedom to assess the likelihood of a payment. “You have to assume 100 percent probability that even the most unlikely event will occur,” said Hogoboom. As a result of this viewpoint, more risk is present in PIPE deals, creating another barrier for smaller public companies to raise capital, he added. Some PIPE issuers could experience large swings in earnings due to a small change in economics from a transaction. Also, this interpretation of accounting policy could have reduced the number of PIPE transactions in the market, according to other sources.

That will change soon. The FASB expects to address these issues in an FASB Staff Position on Friday, October 20, according to Russell Golden, a senior technical advisor at FASB. After a comment period, FASB expects to finalize it sometime in 2007.

The proposal will split the registration payment from the freestanding instrument (the stock, warrant, or whatever form it takes in the deal), and account for both of them separately. Under current rules, the registration payment provision is linked to the instrument. Also in the proposal, firms will be able to assess the likelihood of the payment and account for it when it’s probable the cash payment will be made.

Additionally, FASB expects to issue other issues related to EITF 00-19 that may impact PIPEs in the first quarter of 2007.