SPACs and Valuation of Warrant Liabilities

SPACs, or Special Purpose Acquisition Companies, raise funds from an IPO and are required to make an acquisition (“de-SPAC”) within 24 months. On April 12, 2021, the U.S. Securities and Exchange Commission (SEC) issued a Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (“SPACs”). The statement highlighted the fact that the accounting for complex financial instruments may be challenging, especially with respect to certain agreements commonly found in SPACs. While SPACs have typically classified warrants on their balance sheets as equity, under certain circumstances, the SEC has highlighted that GAAP would require warrants to be classified as a liability and measured at fair value every quarter, with changes in fair value reported in quarterly earnings.

Since the SEC statement was issued in April, all SPACs have reevaluated their historical accounting conclusions and, in many cases, restated their prior financial statements to reflect warrants as a liability. Many SPAC founders who are contemplating a new IPO are now reporting warrants as liabilities from day one. Other SPAC founders are contemplating revisions to warrant agreements which would prevent them from being treated as a liability for accounting purposes.

Valuing SPAC Warrant Liabilities

Generally, SPACs at their IPO issue a publicly traded unit which includes a share of common A stock and a fractional warrant. After a period of time, usually within two months, the warrant and the common A stock detach from the unit, resulting in the warrants (public warrants), the common A stock and the unit all separately traded on an exchange. Many SPACs may also issue class B common stock and private placement warrants (private warrants) to founders or the providers of acquisition capital.

Fair value determinations for complex financial instruments require experienced, informed judgment.  Valuation complexities exist when valuing the public warrants prior to detachment and the private warrants when deemed to have different terms from the public warrants. Generally, a Monte Carlo simulation approach is used to fair value the public warrants. This approach is the well-accepted technique to capture the redemption features akin to a barrier option.

Prior to detachment, the fair value of the public warrants is also used to bifurcate the value of a unit into the common stock and public warrant components. After detachment, public warrants are valued using the observable market price. Private warrants are valued using the Black Scholes model if they have different terms from the public warrants, or are valued using the public warrant price if deemed equivalent to the public warrants. Informed judgement is required when considering the inputs to the simulation and option price models. The key considerations include: identifying comparable SPACs with publicly traded warrants from whom an implied volatility can be derived, the probability of a successful de-SPAC event and the time to the expected de-SPAC.

Impact of Classifying SPAC Warrants as a Liability

Some SPAC founders have argued that the reclassification of warrants from equity to a liability on the SPAC balance sheet is much ado about nothing. The change has no cash impact and the quarterly change in fair value results in non-cash expense or income. The fair value of the warrant liability will increase or decrease depending on several factors, most importantly the change in the underlying share price and the publicly traded warrant price. For example, if the fair value of a SPACs warrant liabilities was $20 million at the IPO date in October, $80 million on December 31, and $60 million on March 31, the SPAC would show an expense of $60 million ($20 mn - $80 mn) for the fourth quarter and income of $20 million ($80 mn - $60 mn) for the first quarter—all non cash.  Yet, many astute SPAC investors realize that the warrant liability provides an indication of potential dilution which will impact public shareholders at the time of a business combination.

SPAC Valuation Considerations

The SEC’s focus on the proper classification and valuation of SPAC warrants was somewhat of a wakeup call for many SPAC founders, boards of directors and the management of de-SPAC’d companies. Using SPAC entities to bring private companies public has increased exponentially over the past year. Agreements which give rise to complex financial instruments should be thoroughly reviewed for the proper accounting treatment, and when required to be reported at fair value, appropriate, informed judgment should be exercised in estimating value.