InfoMemo Audit 2.0 Citlali Perez, Saida Schmidt, Jacob Brownfield, Justin Ricaurte

Scenario Start-up company preparing to launch a mini-laptop Needs $15 million Two current options: Bank Loan Investor Convertible Bond

Start-up company preparing to launch a mini-laptop

Needs $15 million

Two current options:

Bank Loan

Investor Convertible Bond

Loan 10- year 20% Interest Bond 10-year 10% interest Convertible

Loan

10- year

20% Interest

Bond

10-year

10% interest

Convertible

Outline Explanation of Term Sheet Consequences of Term Sheet Scenario 1 Scenario 2 Analysis of Financing Options

Explanation of Term Sheet

Consequences of Term Sheet

Scenario 1

Scenario 2

Analysis of Financing Options

Explanation of Term Sheet

Debt converted into common stock at the creditor’s option. Convertible Bond Stock Bond

Debt converted into common stock at the creditor’s option.

Accounting Guidance APB 14 FAS 133 FAS 84 EITF 98-5 EITF 00-27

APB 14

FAS 133

FAS 84

EITF 98-5

EITF 00-27

1/1/X1 Dr. Cash $15M Cr. Bonds Payable $15M The Balance Sheet Journal Entry for the issuance of the bond

1/1/X1

Dr. Cash $15M

Cr. Bonds Payable $15M

12/31/X1,X2…10 Dr. Bond Interest Expense $1.5M Cr. Cash $1.5M If interest accrued: Dr. Bond Interest Expense $1.5M Cr. Bond Interest Payable $1.5M Journal Entries to record payment on interest

12/31/X1,X2…10

Dr. Bond Interest Expense $1.5M

Cr. Cash $1.5M

If interest accrued:

Dr. Bond Interest Expense $1.5M

Cr. Bond Interest Payable $1.5M

Consequences of Term Sheet Scenario 1

Assumptions No discount or premium to be amortized No debt issuance costs Paid interest each year

No discount or premium to be amortized

No debt issuance costs

Paid interest each year

Conversion After 5 Years *Assuming $1 Par Value 1/1/X6 Dr. Bonds Payable $15M Cr. Common Stock $ 1.5M Cr. APIC $13.5M

*Assuming $1 Par Value

Effect on EPS Prior to Conversion Net Income $10,000,000 Outstanding Shares 2M EPS $5.00 After Conversion Net Income $10,000,000 Outstanding Shares 2M + 1.5M EPS $2.86

Prior to Conversion

Net Income $10,000,000

Outstanding Shares 2M

EPS $5.00

After Conversion

Net Income $10,000,000

Outstanding Shares 2M + 1.5M

EPS $2.86

Sample Footnote Disclosure 0.62 $ 0.48 $ 0.64 $ Diluted net income per share 0.7 $ 0.55 $ 0.72 $ Basic net income per share 69,412 76,516 85,919 Shares used in computation of diluted net income per share 2,548 6,163 6,163 Add: Dilutive effect of convertible debt 5,639 6,254 5,017 Add: Dilutive effect of employee stock options 61,225 64,099 74,739 Shares used in computation of basic net income per share — — (108 Less: Weighted average common shares subject to repurchase 61,225 64,099 74,847 Gross weighted average common shares outstanding Shares (denominator for basic and diluted): 43,321 $ 36,602 $ 55,369 $ Adjusted net income (numerator for diluted) 438 1,421 1,415 Add: Interest expense on convertible notes, net of tax 42,883 $ 35,181 $ 53,954 $ Net income (numerator for basic) 2004 2005 2006 Year Ended December 31,

Consequences of Term Sheet: Scenario 2

Beneficial Conversion Feature Effective Conversion Price $10 < Fair Value of the Stock (@ commitment date) $12 Convertible debt instrument includes a beneficial conversion feature for which a value must be assigned.

Valuation of Beneficial Conversion Feature Fair Value of Stock $12 Conversion Price ($10) Intrinsic Value $2 # of shares x 1.5M Total Intrinsic Value = $3M

Fair Value of Stock $12

Conversion Price ($10)

Intrinsic Value $2

# of shares x 1.5M

Total Intrinsic Value = $3M

Journal Entries for Beneficial Conversion 1/1/X1 Dr. Cash $15M Dr. Bond Discount $3M Cr. Bond Payable $15M Cr. APIC $3M

1/1/X1

Dr. Cash $15M

Dr. Bond Discount $3M

Cr. Bond Payable $15M

Cr. APIC $3M

Interest Expense and Bond Discount Amortization Debt discount…should be amortized as a component of interest expense. $3M/10yrs = $300K/yr *Note: Should use the Effective Interest Rate Method to calculate amortization per EITF 00-27, pars. 19-20

Debt discount…should be amortized as a component of interest expense.

$3M/10yrs = $300K/yr

Journal Entries for Beneficial Conversion 12/31/X1,X2…X7 Dr. Interest Expense $1.5M Cr. Interest Payable $1.5M Dr. Interest Expense $300K Cr. Bond Discount Amort. $300K

12/31/X1,X2…X7

Dr. Interest Expense $1.5M

Cr. Interest Payable $1.5M

Dr. Interest Expense $300K

Cr. Bond Discount Amort. $300K

All unamortized bond discount  Interest Expense $3M/10yrs = $300K/yr $3M – (7yrs x $300K/yr) = $900K Increase equity upon conversion of debt by an amount equal to the carrying value of the debt Bonds Payable = $15M Accounting for Unamortized Bond Discount upon Conversion

All unamortized bond discount  Interest Expense

$3M/10yrs = $300K/yr

$3M – (7yrs x $300K/yr) = $900K

Increase equity upon conversion of debt by an amount equal to the carrying value of the debt

Bonds Payable = $15M

Journal Entries for Beneficial Conversion (After IPO) IPO: 1/1/X8 Dr. Interest Expense $900K Cr. Bond Discount Amort. $900K Dr. Bond Payable $15M Cr. APIC $15M

IPO: 1/1/X8

Dr. Interest Expense $900K

Cr. Bond Discount Amort. $900K

Dr. Bond Payable $15M

Cr. APIC $15M

Analysis of Financing Options InfoMemo

Alternative Financing Instruments Common Stock Bridge Loan Preferred Stock

Common Stock

Bridge Loan

Preferred Stock

Investment Assumptions Company lasts for at least 10 years Investor has 50/50 probability of converting to stock

Company lasts for at least 10 years

Investor has 50/50 probability of converting to stock

Key Good Bad

Equity Dilution Cost Loss of Control Investor-Company Interests Aligned What InfoMemo Cares About

Equity Dilution

Cost

Loss of Control

Investor-Company Interests Aligned

What InfoMemo Cares About Cost Lost Control Aligned Interests Common Bridge Convertible Preferred Loan Good Bad Dilution

Potential ROI Taxes Risk What the Investor Cares About

Potential ROI

Taxes

Risk

What the Investor Cares About ROI Risk Taxes Common Bridge Convertible Preferred Loan Good Bad

The Convertible Bond Dilution Cost Lost Control Aligned Interests ROI Risk Taxes

Recommendation Currently, Convertible Bond best option Solicit More Investors

Currently, Convertible Bond best option

Solicit More Investors

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