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An investment is not substantially similar to common stock if it 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.
For example, if an investee pays dividends on common stock and the investment participates in a substantially similar manner, it indicates that the investment is substantially similar to common stock. Investors should consider whether the investee is expected to pay dividends when determining if participation in dividends is relevant to assessing risks and rewards of ownership.
The ability to convert an investment into that investee’s common stock without any significant restrictions or contingencies may indicate that the investor may participate in capital appreciation of the investee in a manner that is substantially similar to common stock. In making a determination, an investor would also consider the risks inherent in the investment.
Example EM 1-4 and Example EM 1-5 illustrate the evaluation of whether an investment is expected to participate in the risks and rewards of ownership of common stock.
EXAMPLE EM 1-4
Investment expected to participate in risks and rewards of ownership
On January 1, 20X0, Investor purchased a warrant for $1,000,000. The warrant enables Investor to acquire 50,000 shares of Investee’s common stock at an exercise price of $1.50 per share (total exercise price of $75,000). The warrant is exercisable at any time on or before December 31, 20X0. There are no significant restrictions or contingencies associated with Investor’s ability to exercise the warrant. The warrant does not participate in dividends paid to the common shareholders of Investee. However, Investor does not expect Investee to pay dividends to its common shareholders during the exercise period (January 1, 20X0 – December 31, 20X0). On January 1, 20X0, the fair value of Investee’s common stock is approximately $21.00.
Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee.
Is Investor’s investment expected to participate in Investee’s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to Investee’s common stock?
Analysis
Investor can exercise the warrant and convert its investment to common stock at any time during the exercise period, without any significant restrictions or contingencies; therefore, Investor’s investment enables it to participate equally with the common shareholders in increases in Investee’s fair value. Investor also does not expect Investee to pay dividends to its common shareholders during the exercise period; therefore, dividends that could become payable to common shareholders are not expected to result in a difference in the earnings and losses available to the (a) Investor’s investment (warrant) and (b) Investee’s common shares.
Investors have alternatives in making this assessment. In this case, the current fair value of Investee’s common stock ($21.00) is substantially similar to the current fair value of a warrant to purchase one share of common stock ($20.00, or $1,000,000/50,000). Therefore, the warrant’s expected participation in Investee’s capital appreciation and depreciation is substantially similar to the common shareholders’ participation.
As a result, Investor is likely to conclude that, before exercise, the warrant is expected to have risks and rewards of ownership substantially similar to common stock, i.e., the warrant participates 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 the subordination (see EM 1.2.1.1) and obligation to transfer value (see EM 1.2.1.3) criteria in its determination of whether its warrant is in-substance common stock.
EXAMPLE EM 1-5
Investment not expected to participate in risks and rewards of ownership
On January 1, 20X0, Investor purchased a warrant for $150,000. The warrant enables Investor to acquire 50,000 shares of Investee’s common stock at an exercise price of $19.00 per share (total exercise price of $950,000). The warrant is exercisable at any time on or before December 31, 20X0. There are no significant restrictions or contingencies associated with Investor’s ability to exercise the warrant. The warrant does not participate in dividends paid to the common shareholders of Investee. However, Investor does not expect Investee to pay dividends to its common shareholders during the exercise period (January 1, 20X0 – December 31, 20X0). On January 1, 20X0, the fair value of Investee’s common stock is $21.00.
Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee.
Is Investor’s investment expected to participate in Investee’s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to Investee’s common stock?
Analysis
Investor can exercise the warrant and convert its investment to common stock at any time during the exercise period, without any significant restrictions or contingencies; therefore, Investor’s investment enables it to participate equally with the common shareholders in increases in Investee’s fair value. Investor also does not expect Investee to pay dividends to its common shareholders during the exercise period; therefore, dividends that could become payable to common shareholders are not expected to result in a difference in the earnings (and losses) available to the (a) Investor’s investment (warrant) and (b) Investee’s common shares.
The current fair value of Investee’s common stock ($21.00) is substantially different from the current fair value of a warrant (for this scenario, assume intrinsic value equals fair value) to purchase one share of common stock ($3.00, or $150,000/50,000). Therefore, the warrant’s expected participation in Investee’s capital depreciation is substantially different from the common shareholders’ participation. Specifically, Investor’s investment in the warrant has substantially less at risk in the event of capital depreciation than Investee’s common shares.
As a result, Investor is likely to conclude that, before exercise, the warrant is 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. Therefore, the warrant is not in-substance common stock.
Investor would not be required to evaluate the subordination and obligation to transfer value criteria once the risks and rewards of ownership criterion is not met.
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