Biosciences Unlimited Ltd. begins operations on January 2, 2015, with the issuance of 100,000 common shares at $50 per share. The only shareholders of Biosciences Unlimited Ltd. are Rafel Baltis and Dr. Oscar Hansel, who organized Biosciences Unlimited Ltd. with the objective of developing a new flu vaccine. Dr. Hansel claims that the flu vaccine, which is nearing the final development stage, will protect individuals against 90% of the flu types that have been medically identified. To complete the project, Biosciences Unlimited Ltd. needs $10,000,000 of additional funds. The local banks have been unwilling to loan the funds because of the lack of sufficient collateral and the riskiness of the business.
The following is a conversation between Rafel, the chief executive officer of Biosciences Unlimited Ltd., and Dr. Hansel, the leading researcher.
Rafel: What are we going to do? The banks won't loan us any more money, and we need $10 million to complete the project. We are so close! It would be a disaster to quit now. The only thing I can think of is to issue additional shares. Do you have any suggestions?
Oscar: I guess you're right. But if the banks won't loan us any more money, how do you think we can find any investors to buy shares?
Rafel: I've been thinking about that. What if we promise the investors that we will pay them 2% of net sales until they have received an amount equal to what they paid for the shares?
Oscar: What happens when we pay back the $10 million? Do the investors get to keep the shares? If they do, it'll dilute our ownership.
Rafel: How about, if after we pay back the $10 million, we make them turn in their shares for $100 per share? That's twice what they paid for it, plus they would have already received all their money back. That's a $100 profit per share for the investors. Oscar: It could work. We get our money, but don't have to pay any interest, dividends, or the $50 until we start generating net sales. At the same time, the investors could get their money back plus $100 per share.
Rafel: We'll need current financial statements for the new investors. I'll get our accountant working on them and contact our lawyer to draw up a legally binding contract for the new investors. Yes, this could work.
In late 2015, the lawyer and the various regulatory authorities approve the new share offering, and 200,000 common shares are privately sold to new investors at $50 per share.
In preparing financial statements for 2015, Rafel Baltis and Emma Cavins, the con- troller for Biosciences Unlimited Ltd., have the following conversation:
Emma: Rafel, I've got a problem.
Rafel: What's that, Emma?
Emma: Issuing common shares to raise that additional $10 million was a great idea. But . . .
Rafel: But what?
Emma: I've got to prepare the 2015 annual financial statements, and I am not sure how to classify the common shares.
Rafel: What do you mean? It's equity.
Emma: I'm not so sure. I called the auditor and explained how we are contractually obligated to pay the new shareholders 2% of net sales until $50 per share is paid. Then we may be obligated to pay them $100 per share.
Rafel: So . . .
Emma: So the auditor thinks that we should classify the issuance of $10 million as debt, not shares! And if we put the $10 million on the balance sheet as debt, we will violate our other loan agreements with the banks. And if these agreements are violated, the banks may call in all our debt immediately. If they do that, we are in deep trouble. We'll probably have to file for bankruptcy. We just don't have the cash to pay off the banks.
1. Discuss the arguments for and against classifying the issuance of the $10 million of shares as debt.
2. Can you think of a practical solution to this classification problem?