Tranched preferred funding transactions are gaining traction in industries with complex regulatory environments, such as the life sciences industry. This is due, in large part, to their ability to help investors manage the release of funds often in conjunction with future events and/or the attainment of key milestones. Finance and accounting leadership should be aware that these transactions are decidedly more intricate from an accounting and fair value perspective. To that end, we would like to discuss tranched preferred funding rounds and certain key accounting and valuation implications related to such deals.
Venture capital investors are consistently focused on maximizing return on investment and, as such, often seek favorable funding arrangements. The drive to align capital availability with key milestones often results in creative and complex funding models. One approach is to divide a preferred equity funding into two, or more, separate tranches covered by one agreement, general with the same pricing terms: one tranche the investor funds upon execution, while the condition of the second, or additional, tranche fund release is contingent upon some future event(s) or milestone(s).
Tranched preferred funding arrangements have become increasingly common and are often seen as an attractive alternative to typical preferred equity financing, especially in milestone-related industries. From an investor perspective, making additional funding contingent on the company achieving an agreed-upon milestone establishes greater control over the investment. And by putting a timeline in place, tranched preferred deals provide an incentive for the company to achieve the agreed upon milestone(s) in a timely manner to unlock the additional capital. This structure helps venture investors and operating companies align key goals and timelines.
While the tranched preferred model makes sense from an investor and top management perspective, and enables key stakeholder alignment, it is important to understand that these deals introduce a level of complexity from an accounting and valuation perspective as compared to traditional (non-tranched) equity funding. The legal control of the Company and how the deal is ultimately structured will often result in meaningful effort to properly value and place the funding elements on the company’s books.
The particular terms of the financing will ultimately determine how the transaction is accounted for in the company’s financial statements and ultimately whether the Company has to value certain embedded (and/or freestanding) instruments related to the agreement.
In tranched preferred funding deals, both the guaranteed and the contingent portions are written into the same contract. Thus, careful consideration of whether the feature is embedded or freestanding must be performed. Subsequently, there may be a contract liability that must be valued on a recurring basis until the tranche is exercised. These instruments, if required be accounted for separate from the underlying financing agreement, will often result in large non-cash changes to an entities financial results over time. This is a complex analysis and would require technical accounting and valuation expertise to avoid delayed attest compliance deadlines and potential weaknesses in internal control.
To appropriately value contingent rights or obligations, one must consider the impact of the company meeting the milestones to be an inflection point: if the business achieves its milestones, then the value of the underlying asset, and hence the contingent right or obligation, will presumably increase. The magnitude of the inflection point is a function of the current share price, the contingent upside (or downside) values and the probability of success, which is often estimated based on detailed guidance by company management. From there, the impact of the contingent upside and downside values must be considered. It is important to note that tranched preferred financings also have implications with respect to the issuance of equity compensation (IRC 409a/ASC 718) as it relates to fair value estimates for a company’s common stock.
As you can see, valuing and accounting for even just a single contingent right or obligation can become highly complex and technical. A key takeaway for finance leaders and company investors is that the presence of different contingent outcomes in tranched preferred funding deals will almost certainly result in detailed technical accounting and valuation analysis. For companies whose funding rounds include such terms, partnering with experienced specialists in the field can help make the process more painless for the finance and accounting teams and avoid potentially costly delays, from the perspective of delaying the closing of future funding agreements if audited financial statements are required and such instruments have not been properly addressed.