What happens when a company gives its preferred shareholders the right to convert their shares into common shares? To find out, we'll turn to DAVIDsTEA, a company that wants to become the Starbucks of the tea world.
According to the 2016 annual report of DAVIDsTEA, the company had issued at some point in the past about 5,000,000 preferred shares. These were divided into three classes, called A, A-1, and A-2, but reading in the notes to the financial statements, we can see that the classes were extremely similar to each other. All the preferred shares had two conversion features:
- They could be converted into cash, for whatever the shareholders had paid for them plus any unpaid dividends (this total was about $30,000,000). The preferred shareholders never exercised this option, so it looks like it was just a safety valve to protect them in case the company ran into financial difficulty.
- They could be converted into common shares at a rate of 1.6 common shares for every preferred share. So, if they were converted, the preferred shareholders would end up holding about 8,000,000 common shares.
It’s the latter conversion option that was exercised on June 10, 2015. Let’s look at how the company accounted for this event.
Conversion of preferred shares to common shares on June 10, 2015
The preferred shares had been sold to the shareholders at some point in the past for about $26 million. The company also owed over $3 million in unpaid dividends on the shares. Both of these amounts were listed on the 2015 balance sheet as liabilities. By June 10, 2015, the total liability for preferred shares and unpaid dividends was $29.6 million.
Under IFRS, a conversion option is itself considered a liability for the company, over and above the price of the shares and the unpaid dividends. This is because if the shareholders do convert the 5,000,000 preferred shares into 8,000,000 common shares, the company misses out on the price they could get for issuing those common shares into the stock market. In January 2015, this additional liability was valued at $16.4 million, based on a share price of $8.54 per common share (see page 66 of the 2016 annual report). The liability value includes some additional factors besides expected price and number of shares, so it’s not a straightforward multiplication.
When conversion feature was exercised by the preferred shareholders on June 10, 2015, the market price of the common shares was $23.25, not $8.54. So, the opportunity cost of the 8,000,000 common shares was $157 million. (Again, it’s not a straightforward multiplication.)
So, here are the transactions that the company had to record under IFRS in order to complete the conversion:
Note that the $16.4 million existing liability was created at some point in the past by a debit for loss on the fair value of the common shares, and a credit to the liability. That is simply IFRS insisting that if a company promises to give common shares to someone in the future, they have to record the estimated value of that now. We don’t know when the preferred shares were initially issued, but every year, the company would have had to reassess the fair value of the promise and record an additional expense and liability for the difference.
So what happened at the conversion date of June 10, 2015? The company cancelled the 5,000,000 preferred shares and all debts associated with them ($29.6 million), and issued to those shareholders approximately 8,000,000 in newly printed common shares. Since they could, in theory, have sold those shares on the market, they have to record an expense for the money they didn’t get.
In the equity section, what happens is that the share capital goes up by a total of $186.9 million (see the statement of changes in equity for January 2016). That’s a credit because it’s in the equity section. But because they didn’t sell those shares, the debit isn’t to cash, it’s to the liability for the preferred shares that are being cancelled ($29.6 million), the liability for the previously recognized opportunity cost ($16.4 million), and the expense to recognize the loss related to the rest of the opportunity cost ($140.8 million).
This leaves the equity section showing a large increase in share capital, but a big decrease in retained earnings because of the $140.8 million expense.
You’d think that it would have been simpler to just say that the value of the newly issued common shares was $29.6 million and not record anything for the opportunity cost. That’s not how IFRS works, though. IFRS wants stock options and other stock transactions to affect the income statement, so that companies can’t just play stock option games behind the scenes.
By the way, the Canadian government knows full well that the $140.8 million expense wasn’t a “real” expense, so the company was not allowed to deduct it from taxable income on its tax return. (Remember, the taxable income calculation on the income statement is not the same as the taxable income calculation on the tax return. They are all based on the same underlying numbers, but IFRS and the CRA have different rules for when revenue and expenses should be recognized, and what counts as a deductible expense.
Photos of fall leaves taken in Toronto in 2016.