PRIVILEGED & CONFIDENTIAL — ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT
CALDERWOOD & HARKNESS LLP Attorneys at Law 600 Lexington Avenue, 30th Floor New York, New York 10022 Telephone: (212) 558-4000 Facsimile: (212) 558-3588 www.calderwoodharkness.com
April 10, 2023
MEMORANDUM
PRIVILEGED & CONFIDENTIAL — ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT
TO: Jennifer Kwon, Responsible Partner, Capital Markets, Calderwood & Harkness LLP
FROM: Claire Dempsey, Lead Associate, Capital Markets; Leonard Cross, Specialist Partner, Tax
RE: Optiwave Semiconductor Corp. — Accounting and Tax Treatment of $250,000,000 2.75% Convertible Senior Notes due 2028 and Capped Call Transactions
MATTER NO.: 1014-00001
BILLING CODE: 48710-001
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I. Executive Summary and Purpose
This memorandum has been prepared for use by the Calderwood & Harkness LLP ("C&H") deal team advising Optiwave Semiconductor Corp. ("OWS" or the "Company"), a Delaware corporation listed on the Nasdaq Global Select Market under the ticker symbol "OWS" and headquartered at 4800 Great America Parkway, Suite 1200, San Jose, California 95054, in connection with the Company's proposed Rule 144A offering of convertible notes to qualified institutional buyers ("QIBs"). The memorandum addresses two principal areas of analysis:
(a) The accounting treatment under United States generally accepted accounting principles ("U.S. GAAP") of OWS's proposed issuance of $250,000,000 aggregate principal amount (plus up to $37,500,000 under a 15% over-allotment option granted to the initial purchasers, for a potential total of $287,500,000) of 2.75% Convertible Senior Notes due 2028 (the "Notes"), including the treatment of the concurrent capped call transactions entered into with Ridgepoint Capital Markets LLC ("Ridgepoint") (60% allocation) and Northvane Financial Products LP ("Northvane") (40% allocation) (collectively, the "Capped Call Transactions"); and
(b) The United States federal income tax treatment of the Notes, the Capped Call Transactions, and the interaction between the accounting and tax treatment of each.
This memorandum is intended to provide practical guidance to the C&H advisory team and to facilitate coordination with OWS's management, its independent auditor Aldgate & Finch LLP (engagement partner Robert Nishimura), and the initial purchasers' counsel on accounting and tax disclosure matters in connection with the preparation and finalization of the Offering Memorandum. This memorandum is not a formal tax opinion and does not constitute a guarantee of any particular accounting or tax outcome. The conclusions expressed herein are based on the terms as described in the draft Preliminary Offering Memorandum dated April 5, 2023, the draft Indenture dated April 7, 2023, and the draft ISDA Confirmations circulated on April 8, 2023, and are subject to revision upon finalization of the transaction documentation.
Key Conclusions. Subject to the assumptions, qualifications, and open items discussed throughout this memorandum, our principal conclusions are as follows:
1. Notes — Accounting Treatment. Under Accounting Standards Codification ("ASC") Topic 470-20, Debt — Debt with Conversion and Other Options, as simplified by Accounting Standards Update ("ASU") 2020-06, Debt — Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging — Contracts in Entity's Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity's Own Equity, the Notes should be accounted for entirely as a single liability measured at amortized cost. No bifurcation of an equity component is required. Issuance costs of approximately $6,950,000 are deducted from the carrying amount of the liability and amortized as non-cash interest expense over the term to maturity using the effective interest method.
2. Capped Call Transactions — Accounting Treatment. The Capped Call Transactions should be classified in stockholders' equity under ASC 815-40, Derivatives and Hedging — Contracts in Entity's Own Equity. Their aggregate cost of $28,750,000 ($17,250,000 to Ridgepoint and $11,500,000 to Northvane) should be recorded as a reduction to additional paid-in capital ("APIC"). The Capped Call Transactions are not subsequently remeasured at fair value because equity-classified instruments are not subject to mark-to-market accounting.
3. Diluted EPS. Under ASU 2020-06, OWS is required to use the if-converted method for diluted earnings per share ("EPS") calculations for the Notes. Critically, the Capped Call Transactions do not reduce dilution for GAAP EPS purposes because they are equity-classified instruments; the anti-dilutive economic benefit of the Capped Call Transactions is not recognized in diluted EPS under U.S. GAAP.
4. Notes — Tax Treatment. For U.S. federal income tax purposes, the Notes are expected to be treated as "variable rate debt instruments" under Treasury Regulation Section 1.1275-5, with OWS entitled to deduct stated interest of 2.75% per annum on an accrual basis. Issuance costs are amortizable over the term of the Notes.
5. Capped Call Transactions — Tax Treatment. The Capped Call Transactions are expected to be characterized as separate prepaid forward contracts on OWS common stock, governed by Section 1032 of the Internal Revenue Code of 1986, as amended (the "Code"). Under this characterization, the $28,750,000 aggregate premium is non-deductible, consistent with the GAAP treatment. OWS does not intend to elect integration of the Capped Call Transactions with the Notes under Treasury Regulation Section 1.1275-6.
Each of these conclusions is discussed in detail in the sections that follow.
II. Background — Transaction Overview
A. The Notes
The material terms of the Notes, as reflected in the draft Preliminary Offering Memorandum and draft Indenture, are summarized below:
Issuer. Optiwave Semiconductor Corp., a Delaware corporation.
Instrument. 2.75% Convertible Senior Notes due 2028.
Maturity Date. June 1, 2028, unless earlier converted, redeemed, or repurchased.
Interest Rate and Payment Dates. The Notes bear interest at a rate of 2.75% per annum, payable semi-annually in arrears on June 1 and December 1 of each year, commencing December 1, 2023. Interest will be computed on the basis of a 360-day year comprised of twelve 30-day months.
Aggregate Principal Amount. $250,000,000 in base principal amount. The initial purchasers have been granted a 15% over-allotment option exercisable within 13 calendar days of the pricing date, which would provide for the issuance of up to an additional $37,500,000 in aggregate principal amount, bringing the potential total aggregate principal amount of the Notes to $287,500,000.
Offering Structure. The Notes are being offered and sold pursuant to Rule 144A under the Securities Act of 1933, as amended (the "Securities Act"), to QIBs (as defined in Rule 144A). No registration statement is being filed with the Securities and Exchange Commission (the "SEC") in connection with the offering. No registration rights are being granted to the initial purchasers or to holders of the Notes.
Conversion Terms. The initial conversion rate is 10.5820 shares of OWS common stock, par value $0.001 per share (the "Common Stock"), per $1,000 principal amount of Notes, which is equivalent to an initial conversion price of approximately $94.50 per share. The initial conversion price represents an approximate 28.8% premium over the anticipated reference price of $73.38 per share, which is the expected closing sale price of the Common Stock on the Nasdaq Global Select Market on the anticipated pricing date of May 23, 2023.
Settlement. OWS may, at its election, settle conversions of the Notes in (i) cash only, (ii) shares of Common Stock only, or (iii) a combination of cash and shares of Common Stock (referred to as "net share settlement"). Under net share settlement, OWS would pay cash equal to the principal amount of the converted Notes and deliver shares of Common Stock for the conversion value in excess of the principal amount.
Maximum Shares Issuable. Based on the initial conversion rate, the maximum number of shares issuable upon conversion of the Notes is approximately 2,645,500 shares (assuming conversion of $250,000,000 aggregate principal amount) or approximately 3,042,325 shares (assuming conversion of the full $287,500,000 aggregate principal amount, including the over-allotment option).
Optional Redemption. The Notes are not redeemable at OWS's option prior to June 6, 2026. On or after June 6, 2026, OWS may redeem all or any portion of the Notes for cash at a redemption price equal to 100% of the principal amount of the Notes to be redeemed, plus accrued and unpaid interest, if any, to, but excluding, the redemption date, if the last reported sale price of the Common Stock exceeds 130% of the conversion price (i.e., $122.85 per share) for at least 20 trading days (whether or not consecutive) during any 30 consecutive trading day period (including the last trading day of such period) ending on, and including, the trading day immediately preceding the date on which OWS provides notice of redemption.
Fundamental Change Put. Upon the occurrence of a "fundamental change" (as defined in the Indenture), each holder of Notes will have the right to require OWS to repurchase all or any portion of such holder's Notes at a repurchase price equal to 100% of the principal amount of the Notes to be repurchased, plus accrued and unpaid interest, if any, to, but excluding, the fundamental change repurchase date.
Make-Whole Fundamental Change. If a "make-whole fundamental change" (as defined in the Indenture) occurs, the conversion rate will be increased for holders who convert their Notes in connection with such make-whole fundamental change, based on a customary make-whole adjustment schedule set forth in the Indenture.
Ranking. The Notes are unsecured and rank senior in right of payment to any of OWS's indebtedness that is expressly subordinated in right of payment to the Notes, rank equally in right of payment with all of OWS's existing and future unsecured indebtedness that is not so subordinated, and are effectively subordinated to any of OWS's secured indebtedness (including amounts outstanding under the Crestline revolving credit facility described below) to the extent of the value of the collateral securing such indebtedness and structurally subordinated to all existing and future indebtedness and other liabilities of OWS's subsidiaries.
Indenture. The Notes will be issued pursuant to an Indenture (the "Indenture") between OWS and Broadmere Trust Company, N.A., as trustee (the "Trustee"), governed by the laws of the State of New York.
CUSIP and ISIN. CUSIP: 683742AA5; ISIN: US683742AA53.
B. The Capped Call Transactions
Concurrently with the pricing of the Notes, OWS intends to enter into privately negotiated Capped Call Transactions with Ridgepoint and Northvane (collectively, the "Capped Call Counterparties"). The purpose of the Capped Call Transactions is to offset the potential dilution to the Common Stock upon conversion of the Notes or to offset any cash payments OWS is required to make in excess of the principal amount of converted Notes, in each case, up to a specified cap price. The material terms of the Capped Call Transactions are summarized below:
Counterparties and Allocation. Ridgepoint Capital Markets LLC (60% allocation) and Northvane Financial Products LP (40% allocation).
Lower Strike Price. The lower strike price of the Capped Call Transactions is equal to the initial conversion price of the Notes, approximately $94.50 per share, subject to customary anti-dilution adjustments substantially similar to those applicable to the conversion rate of the Notes.
Upper Strike (Cap) Price. The upper strike price (or "cap price") of the Capped Call Transactions is $110.07 per share, which represents a premium of approximately 50.0% over the reference price of $73.38 per share, subject to certain adjustments. This cap price effectively raises the economic conversion price of the Notes from approximately $94.50 per share to approximately $110.07 per share.
Aggregate Capped Call Cost. $28,750,000, allocated as $17,250,000 to Ridgepoint and $11,500,000 to Northvane. This amount is payable by OWS to the Capped Call Counterparties from the net proceeds of the offering of the Notes.
Expiration. The Capped Call Transactions expire on June 1, 2028, which is co-terminus with the maturity date of the Notes.
Documentation. Each Capped Call Transaction will be documented under a 2002 ISDA Master Agreement and a related Confirmation between OWS and the applicable Capped Call Counterparty, governed by the laws of the State of New York.
Economic Effect. The Capped Call Transactions are designed so that if the market price of the Common Stock at conversion is above the initial conversion price of $94.50 but at or below the cap price of $110.07, the Capped Call Transactions will provide OWS with shares (or, at OWS's option, cash) in an amount that offsets the dilution or excess cash payments that OWS would otherwise incur upon conversion of the Notes. If the market price of the Common Stock exceeds the cap price, the Capped Call Transactions will not offset any dilution or excess cash payments above the cap price.
C. Use of Proceeds Summary
The following table summarizes the expected use of proceeds from the offering of the Notes, assuming full exercise of the over-allotment option:
OWS intends to apply the net proceeds first to repay $75,000,000 currently outstanding under OWS's $300,000,000 senior secured revolving credit facility (the "Revolver") with Crestline National Bank, N.A., as administrative agent. The remaining net proceeds (approximately $176,800,000) will be used for general corporate purposes, including working capital, potential acquisitions, and capital expenditures.
D. Key OWS Financial Data
For context in evaluating the accounting and tax analysis set forth herein, the following key financial data points for OWS are relevant:
• FY2022 Revenue: $812.4 million (as reported in OWS's Annual Report on Form 10-K for the fiscal year ended December 31, 2022, filed on February 28, 2023).
• FY2022 Adjusted EBITDA: $198.7 million (as reported in the Company's earnings release and non-GAAP financial supplement filed on Form 8-K on February 7, 2023).
• Market Capitalization (as of March 3, 2023): Approximately $4.3 billion, based on approximately 58.6 million diluted shares outstanding multiplied by the closing sale price of $73.38 per share.
• Authorized Common Stock: 200,000,000 shares, par value $0.001 per share.
• Independent Auditor: Aldgate & Finch LLP (PCAOB-registered), engagement partner Robert Nishimura. Aldgate & Finch LLP has served as OWS's independent registered public accounting firm since the Company's initial public offering in 2016.
III. Accounting Treatment of the Convertible Notes
A. Applicable Accounting Standards — ASC 470-20 and ASU 2020-06
The accounting treatment of convertible debt instruments is governed by ASC Topic 470-20, Debt — Debt with Conversion and Other Options. Historically, ASC 470-20 required issuers of certain categories of convertible debt instruments to bifurcate the proceeds received into a liability component and an equity component, with the resulting difference between the face amount of the instrument and the initial carrying amount of the liability component amortized as additional non-cash interest expense over the term of the instrument. The two principal models that required such bifurcation were:
(i) The "Cash Conversion" Model (former ASC 470-20-25-12 through 25-13), which applied to convertible debt instruments that could be settled partially or wholly in cash upon conversion (sometimes referred to as "cash convertibles" or instruments with "cash settlement features"). Under this model, issuers were required to separately account for the liability component and the equity component by allocating proceeds between the two on the basis of the fair value of a similar instrument without a conversion feature.
(ii) The "Beneficial Conversion Feature" ("BCF") Model (former ASC 470-20-25-5), which applied when the effective conversion price of the convertible instrument was less than the fair value of the underlying equity securities at the commitment date, resulting in an intrinsic value that was allocated to equity.
Both of these models resulted in lower initial carrying amounts for the debt component, the creation of additional paid-in capital in equity, and significantly higher reported interest expense over the life of the instrument due to accretion of the debt discount — even though the issuer's actual cash interest obligation was limited to the stated coupon rate.
In August 2020, the Financial Accounting Standards Board ("FASB") issued ASU 2020-06, which fundamentally simplified the accounting for convertible instruments. ASU 2020-06 eliminated both the cash conversion model and the BCF model for convertible instruments. Under the revised guidance, convertible debt instruments that do not have features requiring bifurcation as derivatives under ASC 815-15, Derivatives and Hedging — Embedded Derivatives, or that are not issued with substantial premiums accounted for as paid-in capital, are accounted for as a single liability unit measured at amortized cost. ASU 2020-06 also revised the earnings per share guidance for convertible instruments, requiring the use of the if-converted method for all convertible instruments and eliminating the availability of the treasury stock method that was previously permitted for instruments settleable in cash.
ASU 2020-06 became effective for SEC-reporting entities (other than smaller reporting companies) for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. OWS is a calendar-year SEC filer that does not qualify as a smaller reporting company. Accordingly, ASU 2020-06 became effective for OWS beginning January 1, 2022, and OWS adopted the standard in its audited financial statements for the fiscal year ended December 31, 2022, as confirmed by its independent auditor, Aldgate & Finch LLP. OWS did not previously have any outstanding convertible debt instruments, so the adoption did not require any cumulative-effect transition adjustments.
B. Elimination of Cash Conversion and Beneficial Conversion Feature Models
Under the pre-ASU 2020-06 rules, the Notes would very likely have required bifurcation under the cash conversion model. The Notes permit OWS to elect net share settlement — that is, settlement of the principal amount in cash and settlement of the conversion value in excess of the principal amount in shares of Common Stock. This net share settlement feature was precisely the type of settlement provision that triggered the cash conversion model under former ASC 470-20-25-12 through 25-13. Under the former rules, OWS would have been required to separate the proceeds of the Notes into a liability component (measured at the fair value of a similar non-convertible instrument, typically resulting in a significant discount to the face amount) and an equity component (representing the residual value attributed to the conversion feature, recorded in APIC). The debt discount so created would have been amortized as additional non-cash interest expense over the expected life of the Notes, resulting in total reported interest expense significantly higher than the 2.75% stated coupon.
With the adoption of ASU 2020-06, neither the cash conversion model nor the BCF model applies. The sole remaining basis for bifurcating a convertible debt instrument is if the instrument contains an embedded feature that meets the definition of a derivative under ASC 815-10 and is required to be bifurcated under ASC 815-15. Accordingly, the analysis turns to whether the Notes contain any embedded derivative features requiring bifurcation.
Embedded Derivative Analysis Under ASC 815-15. We have analyzed each feature of the Notes that could potentially constitute an embedded derivative requiring bifurcation:
(i) Conversion Feature. The conversion feature of the Notes permits holders to convert the Notes into shares of Common Stock (or cash, or a combination thereof, at OWS's election) at the initial conversion rate of 10.5820 shares per $1,000 principal amount, subject to customary anti-dilution adjustments. Under ASC 815-15-25-1, an embedded feature that, if freestanding, would meet the definition of a derivative must be bifurcated from the host contract unless an exception applies. The conversion feature, if it were a freestanding instrument, would be a derivative. However, ASC 815-10-15-74(a) provides that a contract that is indexed to an entity's own stock and classified in stockholders' equity under ASC 815-40 is excluded from derivative accounting. The conversion feature is indexed to OWS's own Common Stock (the exercise contingency is based solely on OWS's stock price, and the anti-dilution adjustments are of the types contemplated by ASC 815-40-15-7A through 7I), and the feature would meet the equity classification criteria of ASC 815-40-25 if it were freestanding (OWS has sufficient authorized shares, there are no net cash settlement requirements outside OWS's control, and OWS is the issuer of the underlying equity). Accordingly, the conversion feature is not required to be bifurcated as a derivative.
(ii) Make-Whole Fundamental Change Adjustment. The Indenture provides for an increase in the conversion rate upon the occurrence of a "make-whole fundamental change," based on a customary table set forth in the Indenture that specifies the incremental shares per $1,000 principal amount based on the stock price and the date of the fundamental change. This feature is economically equivalent to providing holders with additional consideration in connection with a fundamental change and does not alter the conclusion that the conversion feature is indexed to OWS's own stock. Make-whole fundamental change provisions are standard market features and have historically been analyzed by the FASB and practitioners as part of the overall conversion feature rather than as a separate embedded derivative requiring bifurcation. This feature does not create a bifurcation requirement.
(iii) Optional Redemption Feature. OWS's option to redeem the Notes for cash at 100% of principal plus accrued interest on or after June 6, 2026 (subject to the stock price trigger) is a call option held by the issuer. Under ASC 815-15-25-41, a call option held by the debtor that can accelerate the repayment of the debt instrument is "clearly and closely related" to the debt host and is therefore not required to be bifurcated. The redemption price is at par plus accrued interest and does not contain any premium, penalty, or variable pricing feature that would alter this conclusion.
(iv) Fundamental Change Put. The holders' right to require OWS to repurchase the Notes at 100% of principal plus accrued interest upon a "fundamental change" is a put option. Under ASC 815-15-25-42, a put option embedded in a debt instrument that permits the holder to require repayment at par (or at an amount that does not exceed the amortized cost of the debt) upon the occurrence of a contingent event is "clearly and closely related" to the debt host if the debt instrument is not issued at a significant premium or discount. The Notes are expected to be issued at par, and the put price is 100% of principal plus accrued interest, which will not exceed the amortized cost of the Notes at any time. Accordingly, the fundamental change put does not require bifurcation.
Conclusion. Based on the foregoing analysis, no embedded derivative feature of the Notes requires bifurcation under ASC 815-15. The Notes will be accounted for entirely as a single liability measured at amortized cost under ASC 470-20, as amended by ASU 2020-06.
C. Initial Measurement and Subsequent Accounting
Initial Recognition. Upon issuance, the Notes will be recorded on OWS's balance sheet at their initial carrying amount, which is equal to the gross proceeds received from the offering less issuance costs directly attributable to the Notes. Under ASU 2020-06, there is no allocation of proceeds to an equity component; the entire amount of the proceeds (net of issuance costs) is reflected in the liability.
Issuance Costs. Transaction costs directly attributable to the issuance of the Notes include the initial purchasers' discount and the estimated offering expenses. The composition of these costs is as follows:
It is critical to note that the $28,750,000 aggregate premium paid for the Capped Call Transactions is not a debt issuance cost. The Capped Call Transactions are separate, freestanding financial instruments that are accounted for independently from the Notes (as discussed in Section IV below). The capped call premium is a payment for a separate equity-classified instrument and is recorded as a reduction to APIC, not as a cost of issuing the Notes.
Under ASC 835-30-45-3, debt issuance costs are presented on the balance sheet as a direct deduction from the face amount of the related liability. Accordingly, the issuance costs of $6,950,000 will be deducted from the carrying amount of the Notes, creating a debt discount. The initial carrying amount of the Notes on OWS's balance sheet will therefore be:
$287,500,000 (gross proceeds) − $6,950,000 (issuance costs) = $280,550,000
Subsequent Measurement. The Notes will be subsequently measured at amortized cost using the effective interest method in accordance with ASC 835-30. The debt discount of $6,950,000 (representing the deferred issuance costs) will be amortized as additional non-cash interest expense over the period from the issuance date to the maturity date (June 1, 2028), which is expected to be approximately five years (60 months). The amortization is recognized as a component of interest expense in OWS's consolidated statements of operations.
Coupon Interest. The stated coupon interest on the Notes is 2.75% per annum on the aggregate principal amount of $287,500,000 (assuming full exercise of the over-allotment option), which equals $7,906,250 per year. This amount is recognized as interest expense ratably on a semi-annual basis, with payments of $3,953,125 due on each of June 1 and December 1.
Illustrative Effective Interest Rate
The effective interest rate on the Notes will be slightly above the stated coupon rate of 2.75% because of the amortization of issuance costs. Based on a debt discount of $6,950,000 amortized over approximately five years on an aggregate principal amount of $287,500,000, the effective interest rate is estimated to be approximately 2.86% to 2.88% per annum, depending on the exact number of days in each accrual period. Total annual interest expense (cash coupon plus non-cash amortization) is estimated at approximately $9,296,250 ($7,906,250 coupon plus approximately $1,390,000 of annual issuance cost amortization).
D. Conversion Accounting Under ASU 2020-06
The accounting treatment upon conversion of the Notes depends on OWS's settlement election at the time of conversion. ASU 2020-06 simplified the conversion accounting by eliminating the need to track separate liability and equity components, but certain distinctions in settlement method remain relevant.
Net Share Settlement (Cash for Principal, Shares for Excess)
If OWS elects net share settlement (which is the settlement method most commonly expected to be used), the accounting upon conversion is as follows:
(a) OWS derecognizes the carrying amount of the converted Notes from its balance sheet. The carrying amount at the time of conversion will equal the original principal amount less the remaining unamortized issuance costs (i.e., the remaining unamortized debt discount).
(b) OWS pays cash to the converting holder in an amount equal to the principal amount of the converted Notes.
(c) To the extent the cash payment (equal to principal) exceeds the carrying amount of the Notes (which it will if there are remaining unamortized issuance costs), the difference is recognized in earnings as a loss on early extinguishment of debt. Conversely, if for any reason the carrying amount were to exceed the cash paid (which is not expected here), a gain would be recognized.
(d) OWS delivers shares of Common Stock to the converting holder in respect of the conversion value in excess of the principal amount. The shares are recorded at fair value, with a corresponding credit to common stock (at par) and additional paid-in capital.
All-Share Settlement. If OWS elects to settle the entire conversion obligation in shares of Common Stock:
(a) OWS derecognizes the carrying amount of the converted Notes.
(b) OWS credits common stock (at par) and additional paid-in capital for the fair value of the shares issued.
(c) Under ASU 2020-06, the difference between the carrying amount of the Notes and the fair value of the shares issued is not recognized in earnings. Instead, the conversion is treated as an equity transaction, with any difference absorbed in APIC. This is a significant simplification from the prior rules, which required gain or loss recognition on the liability component upon conversion.
All-Cash Settlement. If OWS elects to settle the entire conversion obligation in cash:
(a) OWS derecognizes the carrying amount of the converted Notes.
(b) OWS pays cash to the converting holder in the full conversion value.
(c) The difference between the cash paid and the carrying amount of the Notes is recognized in earnings as a gain or loss on extinguishment.
Induced Conversion Guidance
We note that the "induced conversion" guidance under ASC 470-20-40-15 through 40-19 continues to apply under ASU 2020-06. If OWS were to offer additional consideration (or modify the conversion terms) to induce holders to convert, the fair value of the additional consideration would be recognized as an expense. This guidance would be relevant if, for example, OWS were to sweeten the conversion terms in connection with a fundamental change or a call for redemption in order to incentivize early conversion.
E. EPS Implications Under ASU 2020-06
One of the most significant practical impacts of ASU 2020-06 is the change to the diluted EPS calculation methodology for convertible instruments. Under the prior rules, the treasury stock method was available for convertible instruments that could be settled in cash or a combination of cash and shares (including the net share settlement method applicable to the Notes). Under the treasury stock method, only the shares potentially issuable in excess of the portion that could be settled in cash were included in the diluted share count, and the numerator was not adjusted for interest expense. This method typically resulted in a lower dilutive impact.
ASU 2020-06 eliminates the availability of the treasury stock method for convertible instruments and requires the use of the if-converted method for all convertible instruments, including those with net share settlement features. Under the if-converted method:
(a) The denominator of the diluted EPS calculation is increased by the number of shares that would be issuable if all of the Notes were converted at the beginning of the reporting period (or the date of issuance, if later). Based on the initial conversion rate of 10.5820 shares per $1,000 principal amount and an aggregate principal amount of $287,500,000, the maximum incremental shares for the diluted EPS denominator is approximately 3,042,325 shares.
(b) The numerator of the diluted EPS calculation is adjusted by adding back the after-tax interest expense recognized on the Notes (both the cash coupon and the non-cash amortization of issuance costs) for the reporting period, on the theory that if the Notes had been converted, the interest expense would not have been incurred.
The dilutive impact of the Notes on EPS depends on whether the addition of after-tax interest expense to the numerator is more than offset by the increase in the share count in the denominator. If the Notes are anti-dilutive in a given period (i.e., if the effect of adding back after-tax interest and increasing the share count would increase, rather than decrease, diluted EPS), then the Notes are excluded from the diluted EPS calculation for that period. This determination is fact-specific and must be made each reporting period. We recommend that OWS's finance team, in coordination with Aldgate & Finch LLP, model the dilutive impact under various earnings scenarios in advance of the first quarterly filing following the issuance.
Critical Point — Capped Call Transactions and Diluted EPS. The Capped Call Transactions do not reduce dilution for purposes of the GAAP diluted EPS calculation. Because the Capped Call Transactions are equity-classified instruments that are separate from the Notes, their anti-dilutive economic effect is not taken into account in the diluted EPS calculation under U.S. GAAP. This means that, even though the Capped Call Transactions economically raise the effective conversion price of the Notes from approximately $94.50 to $110.07 per share, the GAAP diluted share count will reflect potential dilution beginning at the initial conversion price of $94.50 per share. This is a counterintuitive result that is frequently a source of confusion for investors and must be prominently disclosed in the Offering Memorandum, the Company's periodic filings, and investor communications.
F. Balance Sheet Presentation and Disclosure
Balance Sheet Presentation
The Notes will be presented on OWS's consolidated balance sheet as a single long-term debt line item, net of unamortized issuance costs. Depending on the proximity of the maturity date and any conversion activity, all or a portion of the Notes may be reclassified to current liabilities in accordance with ASC 470-10-45. Prior to one year before maturity (i.e., prior to June 1, 2027), the Notes should be classified as non-current liabilities.
Income Statement Presentation
Interest expense related to the Notes includes two components: (i) the 2.75% cash coupon and (ii) the non-cash amortization of issuance costs. Both components are presented as interest expense in OWS's consolidated statements of operations. ASU 2020-06 eliminates the significant additional non-cash interest expense that would have arisen under the former cash conversion model from amortization of the equity-component-related discount.
Disclosure Requirements. ASC 470-20-50 sets forth the disclosure requirements for convertible debt instruments. OWS will be required to disclose, at a minimum:
• The principal amount of the Notes outstanding;
• The unamortized issuance costs (debt discount);
• The net carrying amount;
• The fair value of the Notes (generally a Level 2 measurement under ASC 820, based on quoted market prices for the Notes or similar instruments);
• A description of the conversion terms, including the conversion rate, conversion price, and settlement alternatives;
• The maturity date;
• The effective interest rate;
• The amount of interest expense recognized during the period, separately disclosing the contractual interest and the amortization of issuance costs; and
• Any events that would trigger special conversion rights (e.g., fundamental change provisions).
Disclosure of the Capped Call Transactions will be presented separately, as discussed in Section IV below.
IV. Accounting Treatment of the Capped Call Transactions
A. Classification Analysis Under ASC 815-40
The Capped Call Transactions are freestanding financial instruments that are not embedded in the Notes. They are entered into under separate ISDA documentation with the Capped Call Counterparties and have independent legal existence from the Indenture. Accordingly, the Capped Call Transactions must be analyzed independently under ASC 815-10, Derivatives and Hedging — Overall, and ASC 815-40, Derivatives and Hedging — Contracts in Entity's Own Equity, to determine whether they should be classified as equity instruments or as assets/liabilities (derivative instruments) subject to ongoing fair value accounting.
The classification analysis under ASC 815-40 involves two primary inquiries: (1) whether the Capped Call Transactions are "indexed to the entity's own stock" under the indexation guidance of ASC 815-40-15, and (2) whether the Capped Call Transactions meet all of the conditions for equity classification under ASC 815-40-25.
Indexation Test (ASC 815-40-15)
The Capped Call Transactions are structured as call spread overlays on OWS's Common Stock. Each Capped Call Transaction consists of a purchased call option on Common Stock with a lower strike price equal to the initial conversion price of the Notes (approximately $94.50 per share) and a written call option on Common Stock with an upper strike price equal to the cap price ($110.07 per share). Both strike prices are fixed dollar amounts per share, subject to standard anti-dilution adjustments. The settlement amount under each Capped Call Transaction is determined solely by reference to the price of OWS's Common Stock relative to the two strike prices.
ASC 815-40-15-7A through 7I provides guidance on when adjustment provisions in a contract are consistent with the "indexed to entity's own stock" criterion. The anti-dilution adjustment provisions in the draft ISDA Confirmations with Ridgepoint and Northvane are designed to mirror the anti-dilution adjustments applicable to the conversion rate under the Indenture, including adjustments for:
• Stock splits and reverse stock splits;
• Stock dividends;
• Distributions of cash, securities, or other property to holders of Common Stock;
• Tender offers and exchange offers;
• Certain mergers, consolidations, and similar business combinations;
• Spin-offs and similar transactions.
These types of adjustments are expressly contemplated by ASC 815-40-15-7A through 7I as being consistent with the indexation requirement. The Capped Call Transactions do not contain any adjustment provisions that are based on variables other than those used to determine the fair value of a "fixed-for-fixed" forward or option contract on equity shares (e.g., there are no adjustments based on revenue, earnings, or other operating metrics that would take the instruments outside the scope of the indexation test).
Conclusion: The Capped Call Transactions are indexed to OWS's own Common Stock and satisfy the indexation test under ASC 815-40-15.
Equity Classification Conditions (ASC 815-40-25)
ASC 815-40-25 sets forth a series of conditions that must be met in order for a contract that is indexed to an entity's own stock to be classified in stockholders' equity. We have evaluated each of the relevant conditions:
(i) Settlement in Shares or Net Cash at OWS's Election. The Capped Call Transactions provide for settlement in shares of Common Stock or, at OWS's election, net cash settlement. The settlement method is at OWS's control, which is consistent with equity classification. There is no provision in the Confirmations that would require OWS to settle in cash outside of its control (e.g., upon bankruptcy or other events where the counterparty could compel cash settlement).
(ii) Sufficient Authorized and Unissued Shares. OWS must have a sufficient number of authorized and unissued shares of Common Stock available to settle the Capped Call Transactions upon exercise. OWS has 200,000,000 authorized shares of Common Stock, of which approximately 58.6 million diluted shares are currently outstanding or reserved. The maximum number of shares issuable under the Capped Call Transactions is bounded by the number of shares deliverable upon conversion of the Notes (approximately 3,042,325 shares, including shares attributable to the over-allotment option). Even assuming all existing equity awards and the maximum conversion of the Notes, OWS has ample authorized share capacity.
(iii) No Provisions Requiring Net Cash Settlement Outside OWS's Control. We have reviewed the draft Confirmations and confirmed that they do not contain "poison pill" provisions, credit-related triggers, or other provisions that would require OWS to net cash settle the Capped Call Transactions upon the occurrence of events outside OWS's control. Specifically, the Confirmations do not provide for acceleration or net cash settlement upon a decrease in OWS's credit rating, a default under OWS's other indebtedness, or similar events. The only cash settlement mechanics are those elected by OWS at its option.
(iv) OWS is the Issuer of the Reference Equity. The Capped Call Transactions reference OWS's own Common Stock, and OWS is the issuer of that equity. This condition is clearly satisfied.
(v) No Collateral Posting Requirements. The Capped Call Transactions do not require OWS to post collateral (cash or otherwise) during the term of the transactions. The absence of collateral-posting requirements avoids a potential trap under ASC 815-40-25 that could result in liability classification if the collateral arrangement effectively represents a net cash settlement mechanism.
(vi) No Counterparty Rights to Compel Share Delivery in Excess of a Fixed Amount. The Capped Call Transactions are options, not forward contracts; OWS is the purchaser of the call spread, and the counterparties are the writers. The counterparties have no right to compel OWS to deliver shares or cash; rather, OWS has the right to receive shares or cash from the counterparties upon exercise.
(vii) Settlement Amount is Based on a Fixed Number of Shares for a Fixed Monetary Amount. Although the Capped Call Transactions are options (not fixed-for-fixed forward contracts), ASC 815-40-25 permits equity classification for purchased options on the entity's own stock, provided the other conditions are met. The strike prices are fixed, and the settlement amount is determined by reference to a fixed number of shares relative to the fixed strike prices, subject only to standard anti-dilution adjustments.
Conclusion: The Capped Call Transactions meet all conditions for equity classification under ASC 815-40-25. They should be classified in stockholders' equity and are not subject to derivative accounting (i.e., they are not remeasured at fair value at each reporting date).
B. Initial Recognition and Measurement
The aggregate premium paid for the Capped Call Transactions ($28,750,000) is recorded at closing as a reduction to APIC in stockholders' equity. The Capped Call Transactions are not recognized as assets on OWS's balance sheet because they are equity-classified instruments.
The journal entry at the closing date is as follows:
Dr. Additional Paid-In Capital — $28,750,000
Cr. Cash — $28,750,000
The rationale for recording the premium as a reduction to APIC (rather than as an asset or an expense) is that the Capped Call Transactions are contracts on OWS's own equity that are classified in stockholders' equity. Payments made by an entity to acquire its own equity instruments (or instruments classified in equity) are treated as returns of capital, reflected as reductions to equity rather than as assets or expenses.
After initial recognition, the Capped Call Transactions are not subsequently remeasured. Because they are classified in equity, they are not "derivatives" for purposes of ongoing fair value accounting under ASC 815. Changes in the fair value of the Capped Call Transactions do not flow through OWS's income statement or other comprehensive income. The Capped Call Transactions will remain in equity at their initial carrying amount (which is zero on a net basis, as the premium has already been deducted from APIC) until they are exercised, expire, or are otherwise terminated.
C. Income Tax Effect on Equity Classification
The interaction between the equity classification of the Capped Call Transactions and their income tax treatment warrants careful consideration. As discussed in Section V.B below, the Capped Call premium of $28,750,000 is expected to be non-deductible for U.S. federal income tax purposes under the most likely characterization (prepaid forward contracts under Section 1032). However, if any portion of the premium were determined to be deductible (for example, if the IRS or a court were to characterize the Capped Call Transactions differently than expected), the income tax benefit associated with such deduction would be recorded through APIC, not through the income statement. This treatment follows from the principle under ASC 740, Income Taxes, that tax effects of items recorded directly in equity should also be recognized in equity (the "backward tracing" or "tax-in-equity" principle).
If a deductible amount were identified, the journal entry would be:
Dr. Deferred Tax Asset (or reduction of current tax payable) — $28,750,000 × applicable statutory tax rate (21% federal rate, plus state)
Cr. Additional Paid-In Capital — corresponding amount
However, given the expected non-deductibility of the Capped Call premium under current law (as discussed in Section V.B.4 below), we do not expect this entry to be required. OWS's tax position with respect to the Capped Call Transactions should be evaluated under ASC 740-10-25 (the "more-likely-than-not" threshold for recognition of uncertain tax positions) and documented accordingly.
D. Interaction with Diluted EPS
We reiterate the critical point addressed in Section III.E above: the Capped Call Transactions are not reflected in the computation of diluted EPS under U.S. GAAP. Although the Capped Call Transactions economically reduce the potential dilution from the Notes by raising the effective conversion price from approximately $94.50 per share to approximately $110.07 per share, this anti-dilutive benefit is ignored for GAAP diluted EPS purposes because:
(a) The Capped Call Transactions are freestanding instruments that are separate from the Notes;
(b) The Capped Call Transactions are classified in stockholders' equity;
(c) Under U.S. GAAP, only instruments that are dilutive are included in diluted EPS; the Capped Call Transactions, which provide OWS with the right to receive shares (or cash) from the counterparties, are inherently anti-dilutive from OWS's perspective and therefore are excluded from the diluted EPS calculation; and
(d) There is no mechanism under ASC 260, Earnings Per Share, to net the dilutive effect of the Notes against the anti-dilutive effect of the Capped Call Transactions.
The practical consequence of this rule is that OWS's reported diluted EPS will reflect potential dilution from the Notes beginning at the initial conversion price of $94.50 per share, even though the Company has purchased the Capped Call Transactions to offset such dilution up to $110.07 per share. This distinction between economic dilution protection and GAAP-reported diluted EPS is a material disclosure point that must be clearly communicated in the Offering Memorandum, in the Company's periodic filings on Form 10-Q and Form 10-K, and in any investor presentations or earnings calls that reference diluted EPS or share count information.
V. U.S. Federal Income Tax Treatment
A. Tax Treatment of the Convertible Notes
1. Characterization as Debt
For U.S. federal income tax purposes, OWS intends to treat the Notes as indebtedness and not as equity of the Company. The characterization of an instrument as debt or equity for tax purposes is a facts-and-circumstances determination guided by longstanding judicial and administrative authority, including the factors identified in Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968), and the legislative history of Section 385 of the Code. The following factors support the classification of the Notes as indebtedness:
• Fixed Maturity. The Notes have a fixed maturity date of June 1, 2028. There is an unconditional obligation on the part of OWS to repay the principal amount at maturity, regardless of the Company's financial condition or results of operations.
• Unconditional Obligation to Pay Principal. The Indenture contains an unconditional promise by OWS to pay $287,500,000 in aggregate principal amount at maturity (or earlier, upon redemption or fundamental change repurchase). This is a hallmark of indebtedness.
• Stated Interest Rate. The Notes bear interest at a fixed rate of 2.75% per annum, payable semi-annually. The payment of interest is not contingent on the Company's earnings or discretionary. Failure to pay interest constitutes an event of default under the Indenture.
• Senior Ranking. The Notes are senior unsecured obligations of OWS. They are not subordinated to other indebtedness (although they are effectively subordinated to secured indebtedness to the extent of the value of the collateral).
• Wide Distribution. The Notes are being marketed and sold to a broad base of QIBs in a Rule 144A offering. The holders are unrelated institutional investors, not insiders or shareholders of OWS.
• Reasonable Debt-to-Equity Ratio. After giving effect to the issuance of the Notes and the application of proceeds (including the repayment of $75,000,000 under the Revolver), OWS's total indebtedness will be approximately $500–550 million against a market capitalization of approximately $4.3 billion and an equity book value that is comfortably positive. The debt-to-equity ratio is well within the range typically associated with debt characterization.
While the conversion feature of the Notes introduces an equity-like element, the presence of a conversion option does not, standing alone, cause a convertible instrument to be reclassified as equity for tax purposes. The IRS and the courts have consistently treated convertible debt instruments as debt, provided the instrument has genuine debt characteristics (fixed maturity, unconditional repayment obligation, stated interest) and the issuer's intent is to treat the instrument as debt. We conclude that the Notes should be treated as indebtedness for U.S. federal income tax purposes.
2. Original Issue discount (OID) Analysis
The OID analysis for the Notes involves consideration of two distinct issues: (a) whether the Notes are issued at a discount to their stated redemption price at maturity, and (b) whether the conversion feature causes the Notes to be classified as "contingent payment debt instruments" ("CPDIs") under Treasury Regulation Section 1.1275-4.
Issuance at Par. The Notes are expected to be issued at 100% of their principal amount. Accordingly, there is no OID arising from an issuance discount. The "stated redemption price at maturity" (as defined in Treasury Regulation Section 1.1273-1(b)) includes the principal amount but excludes "qualified stated interest" (i.e., the 2.75% coupon, which is payable at fixed intervals of one year or less). Because the Notes are issued at a price equal to their stated redemption price at maturity, there is no OID arising from the issuance price.
Contingent Payment Debt Instrument Analysis. The more complex question is whether the embedded conversion feature of the Notes causes the Notes to be treated as CPDIs under Treasury Regulation Section 1.1275-4. The conversion feature permits holders to receive shares of Common Stock (or cash or a combination thereof) upon conversion, and the value of the conversion right is inherently contingent on the market price of the Common Stock. If the Notes were classified as CPDIs, the interest deduction available to OWS would be computed using the "comparable yield" method and a "projected payment schedule," rather than the stated coupon rate. The comparable yield is the yield at which OWS could issue a fixed-rate, non-convertible debt instrument with terms and conditions similar to those of the Notes (other than the conversion feature). Because the conversion feature has value, the comparable yield of a similar non-convertible instrument would typically be higher than 2.75%, resulting in OID that OWS would be required to accrue (and that would generate additional interest deductions) over the life of the Notes.
Variable Rate Debt Instrument Analysis. OWS intends to take the position that the Notes are "variable rate debt instruments" under Treasury Regulation Section 1.1275-5. Under this regulation, a debt instrument is a variable rate debt instrument if, among other requirements, it provides for stated interest at a "qualified floating rate" or an "objective rate." The conversion option, which provides a return that is contingent on the price of OWS's Common Stock, may be characterized as a contingent payment feature that, under certain interpretations, brings the Notes within the variable rate debt instrument rules rather than the CPDI rules. If the Notes qualify as variable rate debt instruments, the contingent payment rules of Treasury Regulation Section 1.1275-4 would not apply, and interest income and deductions would be determined based on the stated coupon of 2.75%.
OWS's Intended Position. OWS intends to treat the Notes as variable rate debt instruments and to deduct 2.75% stated interest on a semi-annual accrual basis ($7,906,250 per year on the full $287,500,000 principal amount). This is the position most commonly taken by issuers of similar convertible notes, and it is consistent with the market practice that has developed since the IRS issued Notice 2002-36 and subsequent guidance addressing the treatment of convertible instruments.
Caveat. We note that the IRS could challenge OWS's position and assert that the Notes should be classified as CPDIs. If the IRS were successful in such a challenge, OWS's annual interest deduction could be based on a comparable yield higher than 2.75% (potentially in the range of 5.0%–6.5%, depending on OWS's non-convertible borrowing rate at the time of issuance), with adjustments (either positive or negative) upon conversion, redemption, or maturity to account for differences between actual payments and projected payments. While CPDI treatment would generally result in larger annual interest deductions for OWS during the term of the Notes (due to the higher comparable yield), it would also result in more complex tax reporting and could give rise to adjustments (including potential ordinary income) upon conversion or maturity. This risk should be disclosed as a risk factor in the Offering Memorandum.
3. Deductibility of Interest
Assuming the Notes are properly classified as indebtedness for U.S. federal income tax purposes (as discussed above), OWS should be entitled to deduct interest payments on the Notes as ordinary and necessary business expenses under Section 163(a) of the Code.
Section 163(j) Limitation. The deductibility of OWS's business interest expense is subject to the limitation under Section 163(j) of the Code, as amended by the Tax Cuts and Jobs Act of 2017. Under Section 163(j), a taxpayer's business interest expense deduction for any taxable year is limited to the sum of (i) the taxpayer's business interest income, (ii) 30% of the taxpayer's adjusted taxable income ("ATI"), and (iii) the taxpayer's floor plan financing interest. For taxable years beginning after December 31, 2021, ATI is computed without adding back deductions for depreciation, amortization, or depletion (i.e., ATI is more akin to EBIT than EBITDA). Based on OWS's FY2022 Adjusted EBITDA of $198.7 million, and taking into account that ATI will be lower than Adjusted EBITDA after subtracting depreciation and amortization, we estimate that OWS's 30% ATI threshold is comfortably in excess of the annual interest expense of approximately $7.9 million on the Notes (plus OWS's other interest expense, including interest on the Revolver). We recommend that OWS's tax department confirm this analysis based on the Company's detailed tax projections.
Amortization of Issuance Costs. For U.S. federal income tax purposes, issuance costs ($6,950,000 in aggregate) are amortizable over the term of the Notes. Under Section 171 and the applicable regulations, the issuance costs are amortized using either the straight-line method or the yield-to-maturity method, depending on the type of cost and the applicable authority. The annual amortization deduction is approximately $1,390,000 ($6,950,000 ÷ 5 years), recognized as additional interest expense for tax purposes. This deduction is in addition to the 2.75% stated interest deduction.
B. Tax Treatment of the Capped Call Transactions
1. Characterization. The Capped Call Transactions may be characterized for U.S. federal income tax purposes under one of two principal approaches:
(a) Integrated with the Notes. Under the integration rules of Treasury Regulation Section 1.1275-6, a qualifying debt instrument and a financial instrument that together are the economic equivalent of a different debt instrument may be integrated and treated as a single "synthetic debt instrument" for tax purposes. If OWS were to elect integration of the Capped Call Transactions with the Notes, the combined instrument would effectively be a synthetic convertible note with a higher conversion price ($110.07 rather than $94.50), which would modify the projected payment schedule and potentially reduce the OID that would otherwise be calculated under the CPDI rules. OWS does not currently intend to elect integration, and we recommend against doing so because (i) integration would complicate the tax reporting for the Notes, (ii) OWS's intended position is that the Notes are variable rate debt instruments (not CPDIs), so the integration election would be unnecessary and potentially counterproductive, and (iii) the separate treatment of the Capped Call Transactions is consistent with market practice and the economic substance of the transactions.
(b) Separate Prepaid Forward Contracts on OWS Common Stock. Under this approach, which is the more common and expected treatment, the Capped Call Transactions are treated as separate financial instruments — specifically, as prepaid forward purchase contracts on OWS's own Common Stock. The $28,750,000 premium paid by OWS represents the prepaid amount for the right to receive shares (or cash) from the Capped Call Counterparties upon exercise of the call spread. This characterization is governed by the principles of Section 1032 of the Code.
OWS intends to adopt the characterization described in clause (b) above, treating the Capped Call Transactions as separate prepaid forward contracts on OWS's own Common Stock.