2.5 Investments in In-Substance Common Stock
2.5.1 Characteristics of In-Substance Common Stock
ASC 323-10
15-13 For purposes of this Topic, in-substance common stock is an investment in an entity that has risk and reward characteristics that are substantially similar to that entity’s common stock. An investor shall consider all of the following characteristics when determining whether an investment in an entity is substantially similar to an investment in that entity’s common stock:
- Subordination. An investor shall determine whether the investment has subordination characteristics that are substantially similar to that entity’s common stock. If an investment has a substantive liquidation preference over common stock, it is not substantially similar to the common stock. However, certain liquidation preferences are not substantive. An investor shall determine whether a liquidation preference is substantive. For example, if the investment has a stated liquidation preference that is not significant in relation to the purchase price of the investment, the liquidation preference is not substantive. Further, a stated liquidation preference is not substantive if the investee has little or no subordinated equity (for example, common stock) from a fair value perspective. A liquidation preference in an investee that has little or no subordinated equity from a fair value perspective is nonsubstantive because, in the event of liquidation, the investment will participate in substantially all of the investee’s losses.
- Risks and rewards of ownership. An investor shall determine whether the investment has risks and rewards of ownership that are substantially similar to an investment in that entity’s common stock. If an investment is not expected to participate in the earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock, the investment is not substantially similar to common stock. If the investee pays dividends on its common stock and the investment participates currently in those dividends in a manner that is substantially similar to common stock, then that is an indicator that the investment is substantially similar to common stock. Likewise, if the investor has the ability to convert the investment into that entity’s common stock without any significant restrictions or contingencies that prohibit the investor from participating in the capital appreciation of the investee in a manner that is substantially similar to that entity’s common stock, the conversion feature is an indicator that the investment is substantially similar to the common stock. The right to convert certain investments to common stock (such as the exercise of deep-in-the-money warrants) enables the interest to participate in the investee’s earnings (and losses) and capital appreciation (and depreciation) on a substantially similar basis to common stock.
- Obligation to transfer value. An investment is not substantially similar to common stock if the investee is expected to transfer substantive value to the investor and the common shareholders do not participate in a similar manner. For example, if the investment has a substantive redemption provision (for example, a mandatory redemption provision or a non-fair-value put option) that is not available to common shareholders, the investment is not substantially similar to common stock. An obligation to transfer value at a specious future date, such as preferred stock with a mandatory redemption in 100 years, shall not be considered an obligation to transfer substantive value.
15-14 If an investment’s subordination characteristics and risks and rewards of ownership are substantially
similar to the common stock of the investee and the investment does not require the investee to transfer
substantive value to the investor in a manner in which the common shareholders do not participate
similarly, then the investment is in-substance common stock. If the investor determines that any one of the
characteristics in the preceding paragraph indicates that an investment in an entity is not substantially similar
to an investment in that entity’s common stock, the investment is not in-substance common stock. If an
investee has more than one class of common stock, the investor shall perform the analysis described in the
preceding paragraph and the following paragraph (if necessary) by comparing its investment to all classes of
common stock.
15-15 If the determination about whether the investment is substantially similar to common stock cannot be
reached based solely on the evaluation under paragraph 323-10-15-13, the investor shall also analyze whether
the future changes in the fair value of the investment are expected to vary directly with the changes in the fair
value of the common stock. If the changes in the fair value of the investment are not expected to vary directly
with the changes in the fair value of the common stock, then the investment is not in-substance common stock.
Over time, the type and form of investment vehicles have expanded beyond basic voting common stock to include convertible debt, preferred equity securities, options, warrants, interests in unincorporated entities, complex licensing and management arrangements, and a host of other financial instruments. EITF Issue 02-14 (codified in ASC 323-10) noted:
These investment vehicles can convey — by contract, articles of incorporation, indenture, or other means —
any combination of rights, privileges, or preferences including (a) the right to vote with common stockholders,
(b) the right to appoint members of the board of directors, (c) substantive participating rights . . . , (d) protective
rights . . . , (e) cumulative and participating dividends, and (f) liquidation preferences.
Some of these rights may give an investor the ability to exercise significant
influence over the operating and financial policies of an investee without
holding an investment in the investee’s voting common stock. When an investment
in other than common stock (debt, preferred equity securities, etc.) has all the
factors in ASC 323-10-15-13, it is considered to be “in-substance” common stock,
and the investor should apply the equity method if it also has significant
influence over the investee. If the investment does not have all the factors in
ASC 323-10-15-13, it would not be within the scope of ASC 323-10, and the equity
method of accounting would be inappropriate even if the holder of the investment
has significant influence over the investee.
Examples of investments that may have the characteristics of in-substance common stock include convertible stock or warrants (with no barriers to exercise), stock with a nonsubstantive liquidation preference, and participating stock redeemable at the holder’s option. Examples of investments that would generally not be considered in-substance common stock include mandatorily redeemable stock, stock with an embedded non-fair-value put option, stock with a substantive liquidation preference, and nonparticipating, nonconvertible preferred stock.
An investor may also hold an instrument (such as a call or a put option) that gives it the ability to purchase or sell the voting common stock of an investee at some point. In evaluating whether such instruments represent in-substance common stock, an investor must first determine whether the put
or call option is a freestanding instrument. If the instrument is not freestanding, the investor should further determine whether the put or call option is an embedded feature within a host arrangement
that requires bifurcation and separate accounting. The equity method of accounting does not apply to either a freestanding instrument or bifurcated embedded feature since those instruments are accounted for in accordance with ASC 815 (see Section 2.3). Put and call options, as well as other instruments that are not accounted for under ASC 815 (i.e., the host instrument), may have the characteristics in ASC 323-10-15-13 and therefore represent in-substance common stock.
ASC 323-10 contains examples that illustrate the evaluation of whether an investment is in-substance common stock (see Sections 2.5.1.1 through 2.5.1.3). Each example assumes that the investor is not required to consolidate the investee under ASC 810-10, that it has the ability to exercise significant influence over the operating and financial policies of the investee (see Chapter 3), and that its investment does not meet the definition of a derivative instrument under ASC 815.
It is important to note that EITF Issue 02-14 provided the initial guidance on the evaluation of in-substance common stock. Paragraph 5 of EITF Issue 02-14
states, in part:
This Issue does not apply to investments
accounted for under Statement 133, non-corporate entities accounted for
under SOP 78-9, or to limited liability companies that maintain “specific
ownership accounts” for each investor as discussed in Issue No. 03-16,
“Accounting for Investments in Limited Liability Companies.
We believe that the EITF Issue 02-14 scoping guidance continues to be applicable
and, accordingly, the in-substance common stock guidance in ASC 323-10-15-3
through 15-5 should be applied only to investments in corporations. Thus, it
would not apply, for example, to investments in partnerships, LLCs, trusts, or
other unincorporated entities that maintain specific ownership accounts (see
Section 2.2) or
to investments within the scope of ASC 815 (see Section 2.3).
2.5.1.1 Subordination
ASC 323-10
Case A: Subordination Substantially Similar to Common Stock
55-3 Investor organized Investee and acquired all of the common stock of Investee on January 1, 2003. On January 1, 2004, Investee sells 100,000 shares of preferred stock to a group of investors in exchange for $10,000,000 ($100 par value; liquidation preference of $100 per share). The fair value of the entity’s common stock is approximately $100,000 on January 1, 2004.
55-4 In this Case, the stated liquidation preference is equal to the fair value of the preferred stock. However, the fair value of the common stock ($100,000), if compared with the fair value of the preferred stock, indicates that Investee has little or no common stock from a fair value perspective. An investor should therefore conclude that the liquidation preference is not substantive and that the subordination characteristics of its preferred stock investment are substantially similar to the subordination characteristics of Investee’s common stock. The investor should also evaluate whether the preferred stock has the characteristics in paragraph 323-10-15-13(b) through 15-13(c), and paragraphs 323-10-15-14 through 15-15 (if necessary) to reach a conclusion about whether the preferred stock is in-substance common stock.
Case B: Subordination Not Substantially Similar to Common Stock
55-5 Assume the same facts and circumstances as in Case A, except that the fair value of Investee’s common
stock is approximately $15,000,000 on January 1, 2004.
55-6 In this Case, the stated liquidation preference is equal to the fair value of the preferred stock. In addition,
Investee has adequate subordinated equity from a fair value perspective (more than little or no subordinated
equity) to indicate that the liquidation preference is substantive. An investor therefore should conclude
that the subordination characteristics of its preferred stock investment are not substantially similar to the
subordination characteristics of Investee’s common stock. Accordingly, the preferred stock investment is not
in-substance common stock. Evaluation of the characteristics in paragraph 323-10-15-13(b) through 15-13(c)
and paragraphs 323-10-15-14 through 15-15 is not required.
To determine whether a liquidation preference is substantive, an investor should
consider the significance of the stated liquidation preference in relation
to the purchase price of the investment as well as the significance of the
fair value of the subordinated equity (i.e., common stock) of the investee.
Said differently, a stated liquidation preference is not considered
substantive if the investee has little or no subordinated equity from a fair
value perspective. The table below summarizes indicators (not all inclusive)
of whether an investment’s subordination characteristics are substantially
similar to those of common stock.
Substantially Similar | Not Substantially Similar |
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2.5.1.2 Risks and Rewards of Ownership
ASC 323-10
Case C: Investment Expected to Participate in Risks and Rewards of Ownership
55-7 Investor purchases a warrant in Investee for $2,003,900 on July 1, 20X4. The warrant enables Investor to
acquire 100,000 shares of Investee’s common stock at an exercise price of $1.00 per share (total exercise price
of $100,000) on or before June 30, 20X5; the warrant does not participate in dividends. The fair value of the
common stock is approximately $21.00 per share. The warrant is exercisable at any time. Investor does not
expect Investee to declare dividends before exercise.
55-8 Investor should evaluate whether the warrant is expected to participate in Investee’s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock. To evaluate the extent to which the warrant is expected to participate with the common shareholders in Investee’s earnings (and losses), Investor should evaluate whether the warrant allows Investor to currently participate in dividends on a basis substantially similar to common stock. In this Case, Investor does not participate in dividends. Investor, however, can exercise the warrant (convert into common stock) at any time, thereby enabling Investor to participate in Investee’s earnings (and losses) on an equivalent basis to common stock. Because Investor does not expect Investee to declare dividends before exercise, Investor participates in Investee’s earnings in a manner substantially similar to common stock. In addition, warrants that are exercisable into common stock are designed to participate equally with the common shareholders in increases in the Investee’s fair value. Therefore, the warrant participates in Investee’s capital appreciation.
55-9 Investor should also evaluate whether the warrant is expected to participate in Investee’s capital depreciation in a manner substantially similar to common stock. An investor has alternatives for making this evaluation. In this Case, Investor could compare the current fair value of Investee’s common stock with the fair value of the warrant (on an equivalent unit basis) to determine whether the warrant is exposed to capital depreciation in a manner that is substantially similar to the entity’s common stock. The current fair value of the Investee’s common stock of $21.00 is substantially similar to the current fair value of each warrant of $20.04 (on an equivalent unit basis). Therefore, the warrant’s expected participation in Investee’s capital depreciation is substantially similar to the common shareholders’ participation. This comparison of fair values is different from the paragraph 323-10-15-15 evaluation that is performed (if necessary) to determine whether the future changes in fair value of the investment are expected to vary directly with the changes in the fair value of the entity’s common stock.
55-10 Accordingly, Investor should conclude that, before exercise, the warrants are expected to participate in Investee’s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock. Investor should also evaluate whether the warrant has the characteristics in paragraph 323-10-15-13(a) and 323-10-15-13(c) and paragraphs 323-10-15-14 through 15-15 (if necessary) to reach a conclusion about whether the warrant is in-substance common stock.
Case D: Investment Not Expected to Participate in Risks and Rewards of Ownership
55-11 Investor purchases a warrant in Investee for $288,820 on July 1, 20X4. The warrant enables Investor to acquire 100,000 shares of Investee’s common stock at an exercise price of $21.00 per share (total exercise price of $2,100,000) on or before June 30, 20X5; the warrant does not participate in dividends. The fair value of the common stock is approximately $21.00 per share. The warrant is exercisable at any time. Investor does not expect Investee to declare dividends before exercise.
55-12 Investor should evaluate whether the warrant is expected to participate in Investee’s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock. To evaluate the extent to which the warrant is expected to participate with the common shareholders in Investee’s earnings (and losses), Investor should evaluate whether the warrant allows Investor to currently participate in dividends on a basis substantially similar to common stock. In this Case, Investor does not participate in dividends. Investor, however, can exercise the warrant (convert into common stock) at any time, thereby enabling Investor to participate in Investee’s earnings (and losses) on an equivalent basis to common stock. Because Investor does not expect Investee to declare dividends before exercise, Investor participates in Investee’s earnings in a manner substantially similar to common stock. In addition, warrants that are exercisable into common stock are designed to participate equally with the common shareholders in increases in Investee’s fair value. Therefore, the warrant participates in Investee’s capital appreciation.
55-13 Investor should also evaluate whether the warrant is expected to participate in Investee’s capital
depreciation in a manner substantially similar to common stock. An investor has alternatives for making this
evaluation. In this Case, Investor could compare the current fair value of Investee’s common stock with the
current fair value of the warrant (on an equivalent unit basis) to determine whether the warrant is exposed to
capital depreciation in a manner that is substantially similar to the entity’s common stock. The current fair value
of the Investee’s common stock of $21.00 is substantially different from the current fair value of each warrant
of $2.88 (on an equivalent unit basis). Therefore, the warrant’s expected participation in Investee’s capital
depreciation is substantially different from the common shareholders’ participation. This comparison of fair
values is different from the paragraph 323-10-15-15 evaluation that is performed (if necessary) to determine
whether the future changes in fair value of the investment are expected to vary directly with the changes in the
fair value of the entity’s common stock.
55-14 Accordingly, Investor should conclude that, before exercise, the warrants are not expected to participate
in Investee’s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially
similar to common stock and, accordingly, the warrants are not in-substance common stock. Evaluation of the
characteristics in paragraph 323-10-15-13(a) and 323-10-15-13(c) and paragraphs 323-10-15-14 through 15-15
is not required.
To determine whether an investment is substantially similar to common stock, the investor should
assess whether the investment is expected to participate in the earnings (and losses) and capital
appreciation (and depreciation) in a manner substantially similar to how an investment in the investee’s
common stock would participate. The table below summarizes indicators (not all inclusive) of when an
investment has risks and rewards of ownership that are substantially similar to those of common stock.
Substantially Similar | Not Substantially Similar |
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The participation in dividends is a relevant indicator only if the investor expects the investee to pay
dividends to its common shareholders (e.g., during the warrant’s exercise period).
2.5.1.3 Obligation to Transfer Value
ASC 323-10
Case E: Investee Not Obligated to Transfer Substantive Value
55-15 Investor purchases redeemable convertible preferred stock in Investee for $2,000,000. The investment can be (a) converted into common stock valued at $2,000,000 or (b) redeemed for $10,000 at the option of the Investor. The common shareholders do not have a similar redemption feature.
55-16 Investor should evaluate whether exercise of the $10,000 redemption feature obligates Investee to transfer substantive value to Investor and whether the common shareholders do not participate in a similar manner. In this Case, the $10,000 redemption feature is not substantive. Accordingly, Investor should conclude that redeemable convertible preferred stock does not require Investee to transfer substantive value to Investor and that common shareholders do not participate. Investor should also evaluate whether the redeemable convertible preferred stock has the characteristics in paragraph 323-10-15-13(a) through 15-13(b) and paragraphs 323-10-15-14 through 15-15 (if necessary) to reach a conclusion about whether the redeemable convertible preferred stock is in-substance common stock.
Case F: Investee Obligated to Transfer Substantive Value
55-17 Investor purchases redeemable convertible preferred stock in Investee for $2,000,000. The investment can be (a) converted into common stock valued at $2,000,000 or (b) redeemed for $2,000,000 at the option of the Investor. The common shareholders do not have a similar redemption feature. Investor expects that Investee will have the ability to pay the redemption amount.
55-18 Investor should evaluate whether exercise of the $2,000,000 redemption feature obligates Investee to transfer substantive value to Investor and whether the common shareholders do not participate in a similar manner. In this Case, the $2,000,000 redemption feature is substantive because the redemption amount is substantive as compared to the fair value of the investment and, based on Investor’s expectation as of the date that the investment was made, Investee has the ability to pay the redemption amount. Accordingly, Investor shall conclude that redeemable convertible preferred stock requires Investee to transfer substantive value to Investor and that common shareholders do not participate. Accordingly, the redeemable convertible preferred stock is not in-substance common stock. Evaluation of the characteristics in paragraph 323-10-15-13(a) through 15-13(b) and paragraphs 323-10-15-14 through 15-15 is not required.
If the investee is expected to transfer substantive value to an investor and the common shareholders do not participate in a similar manner, an investment is not considered to be substantially similar to common stock. The table below summarizes indicators (not all inclusive) of when an investment is substantially similar to common stock.
Substantially Similar | Not Substantially Similar |
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Only substantive provisions should be considered in the evaluation. Thus, provisions to transfer value
should be evaluated carefully to determine whether they are substantive. For example, as stated in
ASC 323-10-15-13(c), “[p]referred stock with a mandatory redemption in 100 years, shall not be
considered an obligation to transfer substantive value,” since an obligation to transfer value at a date
so far into the future is not considered to be substantive. Further, if, as of the date an investment
was made, an investee does not have the ability to pay the amount to which the investor is (or will be)
entitled, the provision would not be substantive.
2.5.2 Initial Determination and Reconsideration Events
ASC 323-10
15-16 The initial determination of whether an investment is substantially similar to common stock shall be
made on the date on which the investor obtains the investment if the investor has the ability to exercise
significant influence over the operating and financial policies of the investee. That determination shall be
reconsidered if any of the following occur:
- The contractual terms of the investment are changed resulting in a change to any of its characteristics described in paragraph 323-10-15-13 and the preceding paragraph. An expected change in the contractual terms of an investment that are provided for in the original terms of the contractual agreement shall be considered for purposes of the initial determination under paragraph 323-10-15-13 and not as a reconsideration event. However, a change in the form of the investment (for example, debt to equity or preferred stock to another series of stock) is a reconsideration event.
- There is a significant change in the capital structure of the investee, including the investee’s receipt of additional subordinated financing.
- The investor obtains an additional interest in an investment in which the investor has an existing interest. As a result, the method of accounting for the cumulative interest is based on the characteristics of the investment at the date at which the investor obtains the additional interest (that is, the characteristics that the investor evaluated to make its investment decision), and will result in the investor applying one method of accounting to the cumulative interest in an investment of the same issuance.
15-17 The determination of whether an investment is similar to common stock shall not be reconsidered solely
due to losses of the investee.
15-18 If an investor obtains the ability to exercise significant influence over the operating and financial
policies of an investee after the date the investor obtained the investment, the investor shall perform an initial
determination, pursuant to paragraphs 323-10-15-13 and 323-10-15-15, using all relevant and necessary
information that exists on the date that the investor obtains significant influence.
An investor must perform its initial evaluation of whether its investment represents in-substance
common stock when it determines that it has the ability to exercise significant influence over the
operating and financial policies of an investee (see Chapter 3 for further discussion of significant
influence). This date may be after the date its initial investment was acquired.
The investor should continually monitor events and circumstances to determine whether its initial
conclusion should be reconsidered. This reassessment should be performed only if one of the events in
ASC 323-10-15-16 occurs. Although investee losses can significantly change (i.e., reduce or eliminate) the
investee’s capital structure, the investor should not reconsider its initial determination solely because of
such losses (see Section 5.2 for further discussion).
At the time of the initial determination and of any subsequent reassessment, an investor should perform its evaluation on the basis of all facts and circumstances. Accordingly, the investor would consider its cumulative interest in the investee as opposed to only those interests that were recently acquired. The total fair value of an investment as of the date of a reconsideration event should be used in the reconsideration analysis. As a result of the occurrence of a reconsideration event, and on the basis of the investor’s reassessment at that time, an investment that was previously determined not to be in-substance common stock may become in-substance common stock (or vice versa).