Convertible Notes at IPO — ASC 470, ASU 2020-06, and the EPS Question

Convertible notes that are outstanding at the time of an IPO require careful accounting analysis under ASC 470-20 and related standards. The FASB's ASU 2020-06 (effective 2022 for public companies) significantly simplified this analysis by eliminating the requirement to separately account for the equity conversion feature in most cases — but it introduced a new EPS calculation requirement that has direct implications for the S-1.

The ASU 2020-06 Simplification

Before ASU 2020-06 (effective 2022 for larger public companies and fiscal years beginning after December 15, 2023 for everyone else, with early adoption permitted), convertible instruments frequently required separation under the cash-conversion and beneficial-conversion-feature models: the debt host was recorded at a discount, and the conversion feature was separately recognized in additional paid-in capital (APIC). This created non-cash interest expense from the discount amortization and complex accounting entries.

ASU 2020-06 eliminated this bifurcation requirement for most convertible instruments. Under the new model:

• The entire convertible note is recorded as a single liability (the combined debt instrument approach)
• No separate equity component is recognized in APIC for the conversion feature
• Interest expense is lower — no discount amortization from a separately recorded equity component
• The if-converted method for diluted EPS is now required (the treasury stock method is no longer permitted for convertible instruments)

Embedded Derivative Analysis

The analysis runs in two steps. First, is the conversion feature indexed to the company's own stock (ASC 815-40-15)? Variable conversion prices that depend on a future financing round generally fail this step. Second, if indexed, does the feature qualify for equity classification (ASC 815-40-25): settlement in shares within the company's control, sufficient authorized and unissued shares, and no required net cash settlement?

For straightforward startup convertible notes with standard conversion mechanics, the equity classification criteria are typically met and derivative accounting is not required. However, notes with variable conversion rates, anti-dilution features tied to non-standard triggers, or settlement mechanics that depend on external factors may require derivative bifurcation under ASC 815-15. In practice, many startup issuers sidestep the bifurcation mechanics by electing the fair value option (ASC 825) for the entire note — remeasured at fair value each period through earnings, with instrument-specific credit risk in OCI — often the cleanest answer for cap-and-discount notes and an analysis SEC reviewers expect to see documented.

The If-Converted Method for Diluted EPS

Under ASU 2020-06, the if-converted method is required for diluted EPS when a company has outstanding convertible instruments. This method assumes that all convertible notes were converted at the beginning of the period (or the issuance date if later), and includes the resulting shares in the diluted share count while adding back the after-tax interest expense to net income.

For pre-revenue or loss-stage IPO companies where diluted EPS is negative, the if-converted shares are typically anti-dilutive and excluded from the diluted share count — but this must be analyzed for each reporting period.

Accounting at Conversion

When a convertible note converts to equity at an IPO or priced round, the accounting entry derecognizes the debt liability and recognizes the equity issued. Under the simplified ASU 2020-06 model, the conversion is recorded at the carrying amount of the debt (principal plus accrued interest, net of any unamortized issuance costs), with no gain or loss recognized in most standard conversion scenarios.

S-1 Disclosure Requirements

The S-1 must fully disclose outstanding convertible notes, including:

• Principal amounts, interest rates, maturity dates, and conversion terms for each note or note series
• The accounting policy for the convertible notes and the basis for any classification decisions
• The diluted EPS impact using the if-converted method
• Risk factors disclosing that conversion will dilute existing shareholders
• Use-of-proceeds disclosure if IPO proceeds will be used to repay notes rather than convert them

Convertible Note Accounting at IPO — Cases

Airbnb — The 2020 “Convertible” That Wasn't (Debt Plus Warrants)

Airbnb's April 2020 emergency financing is frequently misdescribed as convertible notes that converted at the December 2020 IPO. The record is different: the $2 billion came as first- and second-lien term loans with detachable warrants struck at an $18 billion valuation. Nothing converted at the IPO — the debt stayed debt and was repaid with cash after the offering — and ASU 2020-06 (issued August 2020, effective years later) played no role in the IPO financial statements. The accounting that actually mattered: allocating proceeds between the loans and the warrants created a debt discount amortized through heavy non-cash interest expense, and the warrants — exercisable into redeemable convertible preferred — were liability-classified and remeasured at fair value through earnings until the IPO converted the underlying to common. For S-1 preparers, the case is a reminder to model the instrument you actually issued, not the one the headlines described.

Peloton — $1 Billion Convertible Notes, Post-IPO Interest Expense Impact (2019–2021)

Peloton issued $1 billion in 0% convertible senior notes in February 2021 — approximately 18 months after its September 2019 IPO. The 0% coupon meant no cash interest expense, but once ASU 2020-06 applied on the standard's timeline, the notes were carried as a single liability at amortized cost (principal net of issuance costs), with no separated equity component or discount amortization. For companies preparing pre-IPO financial models, the Peloton convertible note illustrates a common post-IPO capital structure decision: using the public company's lower cost of capital and access to the convertible debt market to raise low-coupon growth capital — dilution contingent on conversion and reflected through if-converted diluted EPS — at rates unavailable in the private debt market. The IPO effectively unlocks the convertible debt market — private companies cannot issue publicly traded convertible notes — which is one of the underappreciated capital structure advantages of being public.

Technical References

Settlement in Cash vs. Shares — Why It Matters

The convertible note instrument itself specifies how it can be settled at conversion: in shares only, in cash only, or in a combination of cash and shares. This settlement flexibility profoundly affects the accounting:

Most pre-IPO convertible notes are structured for mandatory share settlement at the IPO (converting to preferred or common stock) — so the full if-converted share count applies. But startup-stage convertible notes sometimes include a cash settlement option that triggers re-classification as a liability instrument. This matters for the S-1 balance sheet presentation and for diluted EPS.

SEC Comment Patterns on Convertible Note Accounting

The SEC consistently scrutinizes convertible note accounting in technology company S-1s. The most common SEC comments from 2022–2025:

• Beneficial conversion feature (pre-ASU 2020-06 notes): For notes issued before the effective date of ASU 2020-06, the SEC asks whether a beneficial conversion feature (BCF) was recognized — specifically, whether the note's conversion price was below the fair value of the underlying shares on the commitment date. BCF accounting required a debt discount that was accreted over the note's life.
• Modification vs. extinguishment: When a convertible note's terms are amended (maturity extended, interest rate changed, conversion price lowered), the SEC asks whether the modification was so significant that the old note should be treated as extinguished (with gain/loss recognition) and a new note recorded. The 10% cash flow test under ASC 470-50 is the primary test.
• Embedded derivative bifurcation: The SEC reviews whether any conversion features, put options, or call options in the convertible note should be bifurcated as a freestanding derivative under ASC 815. The analysis must be documented and the conclusion defensible — if the conversion feature is indexed to the company's own stock and would be classified as equity, bifurcation is not required.
• Classification as current vs. long-term: If the note matures within 12 months of the balance sheet date, or if the holder has a put option that could force repayment within 12 months, the note must be classified as a current liability — even if the company expects to convert it. The SEC watches for misclassification of near-term notes as long-term.

S-1 Balance Sheet Presentation

The S-1 balance sheet shows the company's financial position at the most recent balance sheet date — which typically includes outstanding convertible notes as liabilities. The presentation requirements:

• Convertible notes are presented as a single line item ("Convertible notes, net") on the balance sheet, with the unamortized debt issuance costs netted against the principal balance
• The footnote disclosure must specify: principal amount, interest rate, maturity date, conversion terms (price per share or conversion mechanics), and any embedded features
• A separate pro forma balance sheet column (or note disclosure) must show the effect of converting all notes to common stock at the IPO — showing how the balance sheet looks immediately after effectiveness before trading begins
• If the convertible notes will be repaid from IPO proceeds rather than converting, the use of proceeds section must disclose the specific amounts to be repaid, the interest rate, and the name of the lender