Tax Trap Convertible Notes with Warrants –

Venture capitalists try to mitigate the risk nature of their investments by diversifying their portfolios, sharing economic risk with other VCs and crafting protective investment instruments. One of the common investment instruments used in the past was convertible preferred shares. If the investment would fail, the VC had a preferred interest in the company’s assets. If it was successful, the VC would convert his interests to common shares and participate in the investment’s success.

However, the optimism of the 1990s has given way to the instability of the 2000s, where market conditions have become quite volatile. As a result, potential investments are no longer judged only by their growth prospects. They are also expected to possess a solid business plan and generate profits in the near future. Start-up entities that have failed to achieve these enhanced results will have likely seen their values decline. For VCs, declining values represents increased risk to their portfolio.

Accordingly, VCs have started to realize that investing in convertible preferred shares no longer provided the necessary security for this increased level of risk. Instead, VCs have recently chosen to invest in convertible debt, since debt-holders have a priority claim to the company’s assets before all equity owners (including preferred shareholders). Therefore, if the investment should fail, the investor has a primary interest in the company’s assets. If the investment is successful, the investor will convert his interests to common shares and participate in the investment’s success.

With the stock market’s continued downward trend and the resulting increased difficulty in raising capital, VCs have become reluctant to invest in many start-ups, even through the relatively safe vehicle of convertible debt. Accordingly, as a means of balancing this increased risk with increased reward, VCs have started demanding that the investee companies add warrants to the debt, at no additional cost to the VCs. Generally, these warrants have an exercise price equal to the fair market value at the time of grant.1

The Tax Trap

While the added warrants have indeed helped keep the venture funds flowing, they have also unwittingly placed the VCs into a detrimental tax position by creating original issue discount (OID) income.

Here is an example of how the process works: a VC invests $1 million in a start-up entity and receives a convertible debt instrument with a $1 million face value, earning interest at a rate of 12%, with maturity in two years. Additionally, the VC receives 500,000 warrants, giving the VC the right to purchase 500,000 shares within the next three years at a price of $1 a share (which approximates the fair market value of the stock on the date that the warrants are granted).

The VC would be required to allocate its $1 million investment between the debt instrument and the warrants (using any recognized method, such as the Black-Scholes formula).2 As a result, if we presume that the warrants are valued at $150,000, then the $1 million debt instrument would have a tax basis of $850,000, causing the VC fund to recognize $150,000 of OID income (which would be taken into income over the life of the debt).3

Planning Alternatives

How can VC funds avoid recognizing OID income while maintaining the current investment system? There are at least three planning alternatives that can help the VC fund avoid, or at a minimum diminish, OID income.

1) No warrants. The VC can purchase only the debt instrument and exclude any warrants from the investment. This approach would certainly remove any concerns of recognizing OID income. However, it may also remove the incentive for the VC to invest.

2) Include warrant-type incentives in debt instrument. The VC should purchase only the debt instrument without accepting a separate warrant instrument. However, the VC fund should demand that the debt instrument be structured to include the warrant-type element within the conversion feature of the debt instrument. This is commonly referred to as a beneficial conversion feature (BCF). Using our example from above, the VC investor could request that the $1million debt instrument have a conversion feature that permits the investor to receive 1.5 million shares upon conversion.4 This would provide the VC with the full benefits of the warrants while avoiding the tax pitfalls of OID income.

It is important to note that although this strategy successfully avoids OID income for tax purposes, it will not help the VC avoid OID income for generally accepted accounting principles (GAAP). Accordingly, this approach would likely impact the audited financial statements and the capital accounts of all the VC partners.

3) Include a valuation in the documentation. The investee company could represent within the debt instrument’s and warrant’s legal documentation that the fair market value of the warrants is less than the value assigned to the stock during the previous financing round. This representation would permit the VC to maintain its current investment structure while reducing its OID income.

This representation could be supported (despite the fact that the investee company’s recent financings may have indicated a higher value) because of any or all of the following:

(a) The previous round was for convertible preferred shares and the warrants are for common shares;

(b) It was easier to raise funds during the earlier round than the current round;

(c) Circumstances have changed that make the company’s prospects riskier (i.e. increased competition, meltdown of the initial public offering market which has made it difficult to raise additional capital, change in the business model, change in management, change in employees, workforce is no longer motivated through options, management’s uncertainty whether it will be able to raise all the necessary capital, etc.);

(d) Management has lost control of the company through dilution and other restrictive covenants. As a result, management can not assure investors that their primary business strategy will be carried out as originally planned. This, in turn, results in the enterprise having a reduced current value when compared to the prior round; and

(e) The business model has changed since the previous round of financing.

For the above relevant reasons, the issuing company can assign a reduced value to the warrant coverage and view that value as the discount off the face of the debt instrument. The VC investor will be subject to OID interest income for only that assigned value.5 However, the taxpayer should be aware that a reduced warrant valuation may be subject to challenge by the IRS.

One additional detail. It is preferable for the VC and the issuing company to assign a valuation to the warrants at the inception of the loan/warrant agreement. However, if they failed to do so at inception, they could still draft a separate “valuation agreement” at a later date in order to memorialize the agreed-upon valuation.

Comparison of OID between GAAP and Tax

Based on these planning techniques, there are times when a single transaction could create starkly different OID results for tax and GAAP.

For example, a VC could find itself strapped into a sizeable OID position for GAAP purposes if it would utilize the aforementioned second planning alternative (i.e. include warrant-type incentives in debt instrument as a beneficial conversion feature) in tandem with issuing separate warrants that have substantial value. In contrast, tax could be able to greatly minimize the OID result.

Adapting from the example above, a VC invests $1 million and receives a convertible debt instrument that permits the investor to receive 1.3 million shares upon conversion (which is essentially a $1 million convertible note coupled with a $300,000 beneficial conversion feature). Additionally, the VC receives warrants that convert into 200,000 shares at an exercise price of $1 per share. Let’s further presume that the BCF has a fair market value of $90,000 and the warrants have a fair market value of $60,000.

For GAAP purposes, the warrants will initially be allocated a portion of the investment cost basis. Since the warrants were valued at $60,000, the debt would have a cost basis of $940,000, which will initially give rise to $60,000 of OID income. However, since this debt converts into 1.300 million shares and the BCF has a fair market value of $90,000, GAAP would recognize an approximate additional $360,000 of OID income (which is the difference between the note’s cost basis of $940,000 and its conversion feature of 1,300,000 shares with a current fair market value of $1 per share). As a result, the total OID income would add up to $420,000 (calculated as the sum of $60,000 value of the warrants and the $360,000 value of the BCF).

Since this is only a GAAP result, this large OID balance would only affect the audited financial statements and the partners’ capital accounts. In contrast, for tax purposes, the OID would initially not exceed $60,000 because the BCF is not a taxable event. If the VC implements the aforementioned third planning alternative (i.e. include a valuation in the documentation), the OID for tax purposes could be drastically reduced even more.

The three previously described alternatives are most useful when the VC fund is aware of the OID issue prior to making their investments into the convertible debts instruments and warrants. With proper tax planning, a VC fund should be able to preserve their existing investing style while still minimizing or eliminating recognition of OID income for tax purposes.

Murray Alter is a Tax Partner at PricewaterhouseCoopers LLP’s specializing in VC partnerships and high-technology companies.

Jonathan Rosenstock is a Tax Manager at PricewaterhouseCoopers in the same practice.

1) In some cases, the warrants have an exercise price below the fair market value at time of grant. This can give rise to additional tax issues that are beyond the scope of this article.

2) The requirement to allocate the purchase price between the debt instrument and the warrants was analyzed in a recent court case (Custom Chrome Inc. v. Comr., 217 F.3d 1117 (9th Cir. 2000)). In that case, the taxpayer borrowed $26 million from First National Bank of Boston. In connection with this loan, FNBB received warrants to purchase up to 12.5% of the stock of the borrower, at $500 per share. The court ruled that the taxpayer had to allocate the costs between the debt instrument and the warrants using “any well-established and reliable method for determining the value of the options.”

3) Even though the warrants appear to have no value on the day of grant (since the exercise price equals the fair market value), the Black-Scholes formula would attribute value to the warrants because of the potential that the shares will increase in value.

4) Under Reg. 1.1272-1(e) and Rev. Rul. 72-265, a convertible debt instrument is treated as a single instrument and not bifurcated into the basic instrument and the conversion right. Therefore, the issue price is completely allocated to the tax basis of the debt instrument and no OID income would result.

5) It is important to note that this solution has real economic substance since it limits the interest deduction the issuer will be able to take. (Naturally, it also serves to limit the interest income the VC investors will have to pick up.) This point is further supported in IRC 1273(c)(2), where the Code mandates that debt instruments that are purchased together with other property, such as options, must have the issue price for each item allocated based on each asset’s relative “fair market value”. Under Reg. 1.170A-1(c)(2), “fair market value” is defined as the price at which the property would “change hands between a willing seller and a willing buyer.” Here, these two willing parties have clearly negotiated a price between them and the IRS should be required to respect that price.