This article is valuation commentary. It is not legal, tax, accounting, or investment advice. Specific engagements depend on facts and applicable professional standards.
This guide explains the rules. How LHM values these instruments is described on the 409A and Complex Securities Valuation page.
Classification decides whether there is a fair value to measure
The first question is where the instrument sits, not how to value it. A warrant or SAFE that lands in liabilities under ASC 480-10-25-8 or ASC 815-40 is measured at fair value when it is issued and remeasured at fair value at each reporting date, with the changes in earnings (ASC 480-10-30-7 and 35-5; ASC 815-40-30-1 and 35-4). An instrument classified in equity is recorded once and not remeasured. Not every liability works this way: a convertible note is usually carried at amortized cost, as the section on notes explains. The analysis runs in a fixed order: ASC 480 first, then ASC 815-40.
ASC 480. An instrument other than an outstanding share is a liability if it embodies an obligation to repurchase the issuer’s shares, or is indexed to one, and may require the issuer to settle by transferring assets (ASC 480-10-25-8). The obligation can be conditional, and the number of conditions does not matter (25-9). That is why a warrant on puttable or redeemable shares is a liability even when the repurchase depends on a defined contingency (480-10-55-33). At venture-backed companies the common case is a warrant on preferred stock that holders can redeem, including on a deemed liquidation such as a sale of the company. Deloitte’s guide notes that the narrow exception for change-of-control redemptions rarely applies to warrants on preferred stock.
ASC 815-40. A warrant outside ASC 480, usually one on common stock, is equity only if it passes two tests. It must be indexed to the company’s own stock: in practice, a settlement equal to the fair value of a fixed number of shares less a fixed strike, adjusted only for inputs to the price of a fixed-for-fixed option (ASC 815-40-15-7 through 15-7F). And it must meet the equity conditions in ASC 815-40-25. Net cash settlement catches the most warrants: a contract that could require cash on an event outside the company’s control is not equity unless the holders of the underlying shares would receive cash too, however unlikely the event (25-8 and 25-9). The company also needs enough authorized and unissued shares, and the contract an explicit limit on the number of shares (25-10).
Classification is not settled at issuance. It is reassessed at each balance sheet date, and a contract moves into or out of equity when the facts change (ASC 815-40-35-8).
| Instrument | Usual classification | Measured at fair value |
|---|---|---|
| Warrant on redeemable or puttable preferred stock | Liability (ASC 480-10-25-8) | At issuance and at every reporting date |
| Warrant on common stock that meets ASC 815-40 | Equity | At issuance, to record it and allocate proceeds; classification reassessed each balance sheet date |
| Warrant that fails indexation or could require cash on an event outside the company’s control | Liability (ASC 815-40) | At issuance and at every reporting date |
| Convertible note with a plain fixed conversion price | Single liability at amortized cost (ASC 470-20, after ASU 2020-06) | Not, unless the fair value option is elected |
| Convertible note that converts at a discount to the next round | Debt host, plus a derivative when the ASC 815-15 criteria are met | The bifurcated feature, at issuance and at every reporting date |
| SAFE with a cash payout on a change of control | Liability (ASC 480-10-25-8) in Deloitte’s analysis; practice varies | At issuance and at every reporting date |
Convertible notes after ASU 2020-06
ASU 2020-06 removed the cash conversion and beneficial conversion feature models. A convertible note is now a single liability at amortized cost unless a feature must be bifurcated under ASC 815 or the note was issued at a substantial premium. SEC filers not eligible to be smaller reporting companies adopted it for fiscal years beginning after December 15, 2021, and all other entities for fiscal years beginning after December 15, 2023, so every company now applies it.
A feature is bifurcated only when it is not clearly and closely related to the debt, the note is not already carried at fair value through earnings, and the feature would be a derivative on its own (ASC 815-15-25-1). Two features in venture notes come out differently. A fixed-price option to convert into a private company’s stock often is not a derivative, because conversion is settled in shares that are not readily convertible to cash. The feature that converts the note at a discount to the next round is analyzed as a share-settled redemption feature, a contingent redemption option, and it meets the net settlement test whether or not the shares are readily convertible to cash (Deloitte Debt Roadmap, Example 8-18). When the discount is substantial, which in practice means 10 percent or more measured against the amount allocated to the debt, the feature is usually bifurcated and carried at fair value (ASC 815-15-25-42). A company can instead elect to carry the whole note at fair value (ASC 815-15-25-4; ASC 825-10).
Warrants issued with a note. When warrants come with debt, the proceeds are split. If the warrants are equity-classified, the split follows the relative fair values of the note without the warrants and of the warrants themselves (ASC 470-20-25-2). If the warrants are liabilities, they take their full fair value first and the note gets the residual. Either way the note usually carries a discount that is accreted to interest expense, and that discount counts toward whether a redemption feature is substantial. A warrant that is never remeasured still needs a fair value on the day it is issued.
SAFEs
No accounting standard is written for SAFEs, and practice varies, so the analysis starts with ASC 480 and the actual terms. Deloitte’s guide concludes that a SAFE giving the holder a cash payout on a change of control is a liability under ASC 480-10-25-8, because a change of control is not within the issuer’s sole control, and that a SAFE in the legal form of debt is a liability outside ASC 480. A liability under 25-8 is measured at fair value at each reporting date, with changes in earnings. At a September 2023 meeting of the FASB’s Private Company Council, a member said most SAFEs end up as liabilities and the chair cited diversity in practice; no practical expedient has followed. The terms still decide it: a SAFE that is a liability only because it settles a fixed dollar amount in a variable number of shares (ASC 480-10-25-14) may be carried at amortized cost instead.
What the SPAC warrant restatements showed
In April 2021 the SEC staff issued a statement on warrants issued by SPACs. Two common provisions, settlement amounts that varied with the characteristics of the holder and tender offer terms that could give every warrant holder cash while only some shareholders received it, led the staff to conclude that the warrants should be liabilities at fair value, with the changes each period in earnings. A wave of restatements followed; Audit Analytics counted warrant-related restatements at more than 600 companies in 2021. The PCAOB staff’s April 2023 spotlight on SPAC audits found deficiencies in 15 of 16 SPAC audits it inspected for 2021, including failures to evaluate bias in the volatility assumption used to value the warrants. The lesson reaches past SPACs: the terms decide the classification, and the classification decides whether there is a fair value to support every quarter.
How the fair value is built
ASC 820 places a measurement in the fair value hierarchy at the level of the lowest-level input that is significant to the whole measurement (ASC 820-10-35-37A). For a private company’s warrants, notes, and SAFEs, that is Level 3, which brings quantitative disclosure of the significant unobservable inputs, with some relief for nonpublic entities (ASC 820-10-50-2). A traded instrument is different: a SPAC’s public warrants can move to Level 1 once they trade.
ASC 820 names option pricing models such as Black-Scholes-Merton and binomial lattice models (ASC 820-10-55-3G). Black-Scholes takes one fixed strike and one expiration date, so it fits a plain warrant whose strike and term are set in the agreement. When the term can end early or turn on an event, such as a forced exercise or conversion in a financing or a sale, a lattice model or a Monte Carlo simulation usually fits better. For SAFEs and notes that convert in a future financing, the useful model weights the outcomes that matter, a priced round, a sale, and a dissolution, each with its own payoff, timing, and probability.
When the strike can change
For a warrant, the strike price is often what decides whether Black-Scholes is enough. More of the warrants we see now carry a strike that can change after issuance. The value of such a warrant depends on what happens before it is exercised: the path of the share price, or the price of a later financing. Black-Scholes has no input for either, so the model has to generate those outcomes and apply the contract to each one. That holds even for an equity-classified warrant, which is valued only once: when it is issued with a note, its issuance-date value allocates the proceeds (ASC 470-20-25-2), and that value should include the reset. These are the forms we see most often:
- Down-round protection. The strike drops if the company later sells shares below the current strike, or issues warrants or other equity-linked instruments with a lower strike. A full ratchet resets the strike to the new price, a weighted-average formula moves it part of the way, and some terms add a floor. The ASC glossary calls this a down round feature, and Deloitte notes that these provisions are frequent in warrants and convertibles issued by private and development-stage companies. On its own, the feature does not make a warrant a liability (see the questions below).
- Price-based resets. On set dates, or after an event such as a reverse stock split or a resale registration taking effect, the strike resets to the lower of the current strike and the market price, often an average of daily volume-weighted prices over several trading days. Some resets also raise the number of shares so the total exercise price stays the same.
- A strike set by the next round. Warrants issued with a bridge note or venture debt often use the next equity round’s price as the strike, sometimes capped at a stated price, and often cover whatever class of shares that round issues. On the issuance date, neither the strike nor the share class is known.
- A strike tied to the business. The strike falls if the company misses a revenue target or a milestone, or it steps up on set dates. A revenue-based reduction also settles the classification: the codification uses it as an example of a warrant that is not indexed to the company’s own stock (ASC 815-40-55-31), so that warrant is a liability measured at fair value at every reporting date.
A binomial lattice builds a tree of possible share prices and applies the contract at each node, so it handles early exercise and a strike that changes on a fixed schedule well. A recombining tree does not record how the price reached a node, though, so a strike that resets on the share price, especially on an average price or the lowest price since issuance, usually fits a Monte Carlo simulation better. The simulation generates thousands of share-price paths and applies the terms along each one, at the cost of extra work when early exercise matters. Down-round protection and a strike set by the next round also need a financing assumption, drawn along each path or set by scenario: when the company raises money, at what price relative to the current value, and how likely that round is to price below the strike. Those inputs are unobservable and usually sensitive, which is how AS 2501.15 describes a significant assumption, so they need support from the company’s cash runway, financing plans, and board materials.
A reviewer can test these models in three ways. The coded terms should match the executed agreement: the reset dates, the averaging window, any floor, and which issuances trigger a down-round adjustment and which are carved out, such as grants under an approved equity plan. When the only difference from a plain warrant is a term that can lower the strike, the result should not fall below a Black-Scholes value at the original strike with the same inputs, and an answer below that floor usually means a term was coded wrong. The answer should also hold steady as the number of simulated paths or lattice steps goes up.
The inputs that move the answer are the value of the underlying share, volatility, expected term, and the probability and timing of the events that trigger conversion or a cash payout. The underlying share value should reconcile to the company’s 409A and ASC 718 work at the same date; a warrant valued on one share price while options are granted on another is the inconsistency a reviewer will ask about first. Volatility is where the PCAOB staff found bias in SPAC warrant audits, and small volatility choices move the value, so the peer set and the term match need support, not just a number.
What the audit team tests
For SEC issuers, AS 2501 requires the auditor to test the company’s process, develop an independent expectation, or evaluate events after the measurement date, alone or in combination (AS 2501.07). Significant assumptions include those that are sensitive to variation or rest on unobservable data (.15). For financial instruments valued with unobservable inputs, the auditor has to understand how those inputs were determined and evaluate whether they are reasonable (.A10). When the company used a specialist, AS 1105 Appendix A applies, including testing the company data the specialist used (.A8). An outside specialist the audit firm engages falls under AS 1210, and one it employs falls under AS 1201 Appendix C. For private company audits, the parallel standard is AU-C 540, as revised by SAS 143 for periods ending on or after December 15, 2023.
PCAOB staff publications show where these files fall short: the company specialist’s report placed in the audit file with no evaluation (spotlight on specialists, February 2025), and significant assumptions tested only by inquiry, recalculation, or vouching to data (Audit Focus on accounting estimates, May 2025). Both are staff views, not rules.
Who prepares the number is settled. Management owns it, usually with a valuation firm as management’s specialist. An SEC issuer’s audit firm cannot prepare it, and for private company audits the AICPA Code bars a valuation that is both significantly subjective and material. The auditor independence guide covers those rules and the two roles an outside firm can play. LHM prepares these valuations for companies and reviews them for audit teams, and it does not review valuation work it performed.
What to have ready before year-end
- The documents. Every warrant, note, SAFE, and side letter, in the executed version, not the term sheet.
- Management’s classification memo, reassessed at the period end (ASC 815-40-35-8), so the valuation answers the right question.
- The cap table and the latest 409A, along with any financing, tender, or sale discussions near the measurement date. Later events can be evidence to the extent they reflect conditions at that date (AS 2501.27).
- A valuation at each reporting date for every liability-classified instrument, plus the issuance-date values used to allocate proceeds.
- A sensitivity table on volatility, term, and the event probabilities, and on the timing and price of the next financing when the strike depends on it, since that is where the review will focus.