In this uncertain market, many public companies that find themselves short on cash are turning to PIPEs as a reliable and quick source of funds. Many investors in these “Private Investments in Public Equity” are private equity sponsors who may already have an interest in the issuer or who may be investing as part of a larger strategic transaction. Of the 15 or so significant PIPE transactions effected in the last month and a half, a majority of them are structured as convertible preferred stock. These instruments tend to be flexible and bespoke, with a variety of economic levers that may be balanced against one another. An issuer, for instance, might accept a lower conversion price or higher coupon in exchange for stronger forced conversion rights, weaker holder put rights, or other favorable terms.
Most convertible preferred instruments are structured to allow holders to participate with the common in liquidation and with respect to dividends. This means that holders of participating convertible preferred stock will receive not only their preferred dividend but also their pro rata share of dividends paid to the common. For instance, if a company with 100 million shares of common stock outstanding and preferred stock that is convertible into 10 million shares of common stock declares a $1.00 per share common dividend, the common holders would receive $100 million in the aggregate, while the convertible preferred holders would receive $10 million (in addition to any preferred dividends they may be owed). Preferred might also be structured with limited participating rights; for instance, preferred holders may be entitled only to the greater of the preferred dividends and the common dividends; in that case, the preferred holders are not entitled to “double dip”: they either participate in common dividends or preferred dividends, but not both.
The convertible preferred instruments issued recently have generally been structured as participating. This participating feature raises a curious accounting consideration—one that rarely seems to be discussed or even understood during negotiations, yet one that can have a significant dilutive effect on the issuer’s earnings per share. To see how this can happen, let’s take a look at a somewhat oversimplified example.
Consider a convertible preferred instrument with a liquidation value of $100 million, a conversion price of $4.00 and a coupon of 7% (this could be payable in cash, in kind, or a combination of both). Our issuer, XYZ Co., which has 200million common shares outstanding, earned $250 million during the year. If the convertible preferred instrument did not participate, XYZ Co.’s basic earnings per share (EPS) would be $1.22, calculated as follows:
- Earnings available to the common equals the $250 million less preferred dividends of $7 million, or $243 million. Divide that figure by the number of common shares outstanding, or 200 million, and we arrive at the $1.22.
If the convertible preferred does participate, however, a different accounting methodology, the two-class method, must be used. The two-class method allocates earnings to each class of stock (in our example, common and preferred), resulting in EPS calculations for each class, after taking into account dividends declared or accumulated and assuming that all undistributed earnings are distributed during the relevant period. This approach requires that a pro rata portion of net income be allocated to the participating convertible preferred, leaving less for the common. Using the same assumptions as above, let’s now calculate basic EPS using the two-class method:
- We now allocate a pro rata portion of earnings after preferred dividends to the preferred on an as-converted basis. Because the preferred is convertible into 25 million shares of common stock, we allocate 25/(25+200) of the $243 million, or $27 million, to the preferred, leaving $216 million for the common. Dividing by the 200 million shares of common stock outstanding yields $1.08.
As the above example demonstrates, the application of the two-class method due to the participation feature can result in significant dilution to basic EPS—in the case above, by 11.5%. And yet, in our experience issuers do not seem to factor in this dilution when negotiating a PIPE. Why not? It is certainly possible that some companies may not be aware of the effects of the two-class method of calculating EPS, at least until the die has already been cast. It is also true that companies that seek PIPE financing are often in urgent need of the money, and are probably less concerned about earnings dilution. Moreover, the speed with which these deals are often executed may leave little time to ponder accounting intricacies.
Why do these instruments so often include a participation feature? After all, from the issuer’s perspective, participating preferred holders are receiving two layers of dividends, the best of both worlds. The investor might argue that this is exactly the point. Because its investment is intended to be equity-like, the investor should be entitled to whatever the common gets, but because the investor has negotiated for the debt-like protections of a preferred instrument, holders should be entitled to dividend protection as well, in the form of preferred dividends. Of course, one would expect an investor to insist that if the preferred does not participate, the issuer should not be permitted to pay dividends on the common without the consent of the preferred holders if dividends are not also paid on the preferred.
There is a tax benefit as well to structuring the preferred with the participation feature. In general, preferred dividends will generate taxable income to the holder—but if the dividends are paid in kind (PIK) rather than in cash, holders will need to obtain cash elsewhere to pay the tax. If, however, the instrument is treated as common from a tax perspective, the preferred dividends, including those paid in kind, are generally not taxable (some exceptions do apply). Making the instrument participate in common dividends goes a long way to ensuring that it is treated like common by the tax authorities.
In situations where the preferred does not participate in common dividends, the market has developed other workarounds to avoid current tax on non-cash dividends. The most common alternative is to have the preferred dividends accrue rather than declaring PIK dividends. How comfortable holders and issuers will be that a particular structure avoids current tax on non-cash dividends will depend on the specific facts of each case.
The takeaway is that if a company is sensitive to its reported EPS, investors and the company should consider designing its convertible preferred PIPE instrument to be non-participating, which will avoid diluting basic EPS in unexpected ways. Issuers should, however, expect to concede other economic points to investors in exchange, but they should at least consider whether reported EPS is of sufficient importance to try to negotiate a non-participating instrument.
This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.
Andrew Bab is a corporate partner and member of Debevoise Plimpton’s mergers & acquisitions and private equity groups, and co-head of the healthcare & Life Sciences Group. The author thanks Richard Sola of PwC for his input on this article.