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An investment without a stated liquidation preference, or with a nonsubstantive liquidation preference, over the investee’s common stock, may be substantially similar to common stock and further analysis of the other criteria will be needed. In contrast, an investment with a substantive liquidation preference over common stock is not substantially similar to that entity’s common stock. An investor should consider the following when assessing if a stated liquidation preference is substantive:
  • The liquidation preference may be substantive if it is significant in relation to the purchase price of the investment.
  • A liquidation preference in an investment is more likely to be substantive when the fair value of subordinated equity (i.e., the investee’s common stock) is significant. Conversely, if there is little or no fair value associated with the investee’s common stock, the investment would participate in substantially all of the investee’s losses in the event of liquidation, and the liquidation preference would not be considered substantive.
Example EM 1-1, Example EM 1-2, and Example EM 1-3 illustrate the evaluation of whether an investment has substantially similar subordination as common stock.
EXAMPLE EM 1-1
Investee’s common stock has little fair value
On January 1, 20X0, Investor purchased 200,000 shares of preferred stock of Investee in exchange for $20,000,000 ($100 par value, liquidation preference of $100 per share). On January 1, 20X0, the fair value of Investee’s outstanding common stock was $300,000.
Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee.
Are the subordination characteristics of Investor’s investment in the preferred stock of Investee substantially similar to the subordination characteristics of Investee’s common stock?
Analysis
The liquidation preference stated in the preferred stock of Investee is equal to the purchase price (and fair value) of the preferred stock on the date of purchase. Therefore, the stated liquidation preference is significant in relation to the purchase price of the investment. However, the fair value of Investee’s common stock ($300,000), compared to the fair value of Investee’s preferred stock ($20,000,000), indicates that Investee’s common stock has little fair value compared to the investment.
In the event of liquidation, Investor’s investment, while preferred stock, would likely participate in substantially all of Investee’s losses. As a result, it’s likely that the liquidation preference in its investment in the preferred stock of Investee is not substantive and that the subordination characteristic of its investment in the preferred stock of Investee are substantially similar to that of the Investee’s common stock.
Investor should also evaluate the risks and rewards of ownership (see EM 1.2.1.2) and obligation to transfer value (see EM 1.2.1.3) to determine whether its investment in the preferred stock of Investee is in-substance common stock.
EXAMPLE EM 1-2
Liquidation preference is insignificant in relation to the purchase price of the investment
On January 1, 20X0, Investor purchased 200,000 shares of preferred stock of Investee in exchange for $20,000,000 ($100 par value, liquidation preference of $1 per share). On January 1, 20X0, the fair value of Investee’s outstanding common stock was $100,000,000.
Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee.
Are the subordination characteristics of Investor’s investment in the preferred stock of Investee substantially similar to the subordination characteristics of Investee’s common stock?
Analysis
The liquidation preference stated in the preferred stock of Investee is equal to 1% ($1 per share divided by $100 per share) of the purchase price (and fair value) of the preferred stock on the date of purchase.
The fair value of Investee’s common stock ($100,000,000), as compared to the fair value of Investee’s preferred stock ($20,000,000), indicates that Investee has significant value associated with its common stock from a fair value perspective.
Given that the liquidation preference is only 1% of the purchase price, Investor is likely to conclude that the liquidation preference of its investment is not substantive and that the subordination characteristic is substantially similar to the subordination characteristics of Investee’s common stock.
Investor should also evaluate the risks and rewards of ownership (see EM 1.2.1.2) and obligation to transfer value (see EM 1.2.1.3) criteria in its determination of whether its investment in the preferred stock of Investee is in-substance common stock.
EXAMPLE EM 1-3
Subordination is not substantially similar to common stock
On January 1, 20X0, Investor purchased 200,000 shares of preferred stock of Investee in exchange for $20,000,000 ($100 par value, liquidation preference of $100 per share). On January 1, 20X0, the fair value of Investee’s outstanding common stock was $100,000,000.
Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee.
Are the subordination characteristics of Investor’s investment in the preferred stock of Investee substantially similar to the subordination characteristics of Investee’s common stock?
Analysis
The liquidation preference stated in the preferred stock of Investee is equal to the purchase price (and fair value) of the preferred stock on the date of purchase and, consequently, the stated liquidation preference is significant in relation to the purchase price of the investment. Further, the fair value of Investee’s common stock ($100,000,000), as compared to the fair value of Investee’s preferred stock ($20,000,000), indicates that the Investee common stock has significant fair value.
Therefore, in the event of liquidation, Investor’s investment in the preferred stock of Investee would likely be protected through the existence of Investee’s common stock, which would most likely absorb a substantial portion of the losses of Investee. As a result, Investor might conclude that the liquidation preference in its investment in the preferred stock of Investee is substantive and that the subordination characteristics of its investment in the preferred stock of Investee are not substantially similar to the subordination characteristics of Investee’s common stock. If so, the preferred stock would not be considered in-substance common stock.
Investor would not be required to evaluate the risks and rewards of ownership and obligation to transfer value criteria once the subordination criterion is not met.
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