Redemption Features in Warrants: A Guide to Classification

A warrant enables its holder to purchase shares of the issuer’s stock at a specified price within a specified period of time. Depending upon the terms of the warrant, as well as the terms of the underlying shares, warrants can be classified as either a liability or an equity instrument.

The classification can have a significant impact on a Company’s financial statements, particularly so with liability classified warrants because they are required to be carried at fair value. The proper classification of a redeemable warrant can be especially tricky, which is what we will focus on today.

When a warrant is redeemable, the issuer of the warrant may be obligated to repurchase the warrant at some point in the future. A redeemable warrant is a warrant that is:

Redeemable warrants and warrants for redeemable shares are generally classified as liability warrants because the issuer has a potential obligation to repurchase the shares for cash.

When examining the classification of a warrant, not only should the warrant itself be examined, but the underlying shares that the warrants are exercisable for should be examined as well. If the underlying shares are potentially redeemable shares, the warrant is most commonly classified as a liability. Both preferred stock and common stock can be redeemable, although the latter is less common.

In order to trigger liability classification of the warrant, the underlying shares can be redeemed either automatically or based on an event that may or may not happen in the future (a conditional event). Despite the fact that the underlying share itself may be equity classified, the potential obligation to transfer assets exists and therefore results in liability treatment of the warrant. Warrants whose underlying shares are redeemable based on a conditional event must be examined closely to determine proper classification of the warrant as there are many subtle terms that could affect their treatment.

This article discusses several of the many considerations that should be taken when reviewing warrants for proper accounting treatment and presentation. Warrants are complex financial instruments that require careful examination of their terms. Each warrant has its own nuances and companies should consult with their accounting professionals to ensure that all terms are considered before treatment of the warrants is determined and before they are valued and recorded.

The information contained herein is not necessarily all inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals.