Penny warrants: Understanding the accounting challenges

Navigating the accounting for pre-funded warrants, commonly referred to as penny warrants, can feel like entering uncharted territory. The accounting guidance is complex, unclear and often inaccessible to those without specialized experience. For many deal teams, the focus is on raising funds, with finance and accounting teams scrambling to account for these transactions once the deal is done.

Unfortunately, standard accounting resources provide little to no actionable guidance, leaving teams to rely on external advisors or risk errors in their financial reporting. This article breaks down the purpose of penny warrants, describes the challenges they present and provides a framework to help you understand these transactions. Our goal is to give you a clear starting point, while encouraging you to reach out for support on accounting and valuation.

Whether you’re an everyday certified public accountant, a finance professional or part of a deal team, this guidance is designed to demystify penny warrants—and reveal why navigating them without the right experience can be a costly mistake.

What are penny warrants?

A penny warrant is an equity instrument with largely the same features as other types of warrants but a de minimis exercise price, often of one penny or less. Penny warrants are usually offered as a component in a broader equity or debt financing transaction. The exercise price of penny warrants is considered to have been funded up front with the broader debt or equity transaction, with only a nominal amount due to be paid on actual exercise. Other features—such as time to expiration and the underlying instrument (that the warrants exercise into)—will vary, depending on the penny warrant agreement.

What benefits do they offer?

Investors are often prohibited from having equity ownership in a company above a certain threshold, either for regulatory reasons or because it would require shareholder approval. Holding pre-funded warrants enables an investor to avoid certain ownership thresholds and additional reporting obligations. At the same time, the investor substantively participates in the equity upside and downside as if they own the underlying shares (due to the de minimis strike and the inclusion of certain participation rights). 

What are the accounting considerations?

Similar to any equity contract, pre-funded warrants are assessed for appropriate classification at issuance. If the warrants are not compensatory within the scope of ASC 718, they are assessed under ASC 480 and ASC 815 to determine whether liability accounting is required. If liability accounting is not required because the instruments are considered indexed to and settled in the issuer, then they are classified in equity.

Accounting considerations specific to a pre-funded warrant, which may not apply to other warrants, include:

• The treatment of these contracts in calculating basic and diluted earnings per share
• Careful review of the contractual terms to understand all potential settlement scenarios and the company’s settlement obligations

How are pre-funded warrants valued?

The value can be approximated by the value of the underlying stock, as the difference between a pre-funded warrant and the underlying instrument is the de minimis strike price of one penny or less. As such, the fair value of a pre-funded warrant may be considered essentially the same as the fair value of the underlying equity share.

For arm’s-length transactions involving penny warrants and at least one other instrument, an obvious but crucial valuation consideration is that the total funding received must reflect the combined value of all instruments offered in the transaction. For example, if $100 million in financing is received for (1) a term loan and (2) penny warrants, the term loan’s value must reflect that only a portion of the $100 million is assignable to it. The rest of the $100 million would be allocated to the penny warrants (even if the penny warrants are specifically intended as “sweeteners”). The same holds true for penny warrants issued with any other financial instruments in a basket transaction.

Where can I obtain additional information on pre-funded warrants?

Utilizing pre-funded warrants can be complex, but consulting an experienced advisor can help. By leveraging this critical advice and guidance, you can better understand how to use penny warrants, including how to effectively approach their valuation and accounting.

RSM’s complex financial instruments accounting and valuation teams offer specialized technical accounting and valuation services to advise and navigate clients through critical matters associated with pre-funded warrants.