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An investment is not substantially similar to common stock if the investee is expected to transfer substantive value to the investor that is not also available to common shareholders. An example of this may be an investment that includes a fixed price mandatory redemption provision or a non-fair value put option that is not available to common shareholders.
An investor should evaluate whether provisions to transfer value are substantive obligations. For example, preferred stock with a mandatory redemption in 100 years is not considered a substantive obligation to transfer value through the redemption feature, given the extreme long-dated nature of the specified future date. Alternatively, if an investee does not have the ability to pay the related redemption price that the investor is or would be entitled to at the time of investment, the redemption provision would also not be considered a substantive obligation to transfer value.
Example EM 1-6 and Example EM 1-7 illustrate the assessment if an Investee is obligated to transfer substantive value.
EXAMPLE EM 1-6
Investee not obligated to transfer substantive value
On January 1, 20X0, Investor purchased 1,000,000 shares of redeemable convertible preferred stock in Investee for $5,000,000. At the date of the investment, 100% of Investee’s common stock was valued at $400,000. The preferred shares can be converted into common shares on a one-for-one basis, or redeemed for $5,000,000. The common shareholders of Investee do not have a redemption feature.
Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee.
Does the redemption feature obligate Investee to transfer substantive value to Investor that is not also available to common shareholders?
Analysis
The $5,000,000 redemption feature is substantive as compared to the fair value of the investment ($5,000,000) on the investment date. However, given that the fair value of the Investee’s common stock was $400,000, Investor is likely to conclude that Investee would not have the ability to pay the redemption amount if exercised. If Investee’s operating results deteriorated, the common shareholders would not be able to absorb significant losses and it would be unlikely that Investee would have the ability to redeem Investor’s preferred stock at the $5,000,000 redemption amount. Therefore, Investor’s redemption feature is not considered substantive as Investee is not expected to transfer substantive value to the Investor.
Investor should also evaluate the subordination (see EM 1.2.1.1) and risks and rewards of ownership (see EM 1.2.1.2) criteria in its determination of whether its investment is in-substance common stock.
EXAMPLE EM 1-7
Investee obligated to transfer substantive value
On January 1, 20X0, Investor purchased 1,000,000 shares of redeemable convertible preferred stock in Investee for $5,000,000. At the date of the investment, 100% of Investee’s common stock was valued at $10,000,000. The preferred shares can be converted into common shares on a one-for-one basis, or redeemed for $5,000,000. The common shareholders of Investee do not have a redemption feature.
Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee.
Does the redemption feature obligate Investee to transfer substantive value to Investor that is not also available to common shareholders?
Analysis
The redemption feature is substantive. The fair value of Investee’s common stock was $10,000,000 and Investor concluded when it made the investment that Investee had the ability to pay the redemption amount if exercised. Therefore, Investor’s investment in the redeemable convertible preferred stock obligates Investee to transfer substantive value to Investor that is not available to Investee’s common shareholders. As such, the redeemable convertible preferred stock is not in-substance common stock.
Investor would not be required to evaluate the subordination and risk and rewards of ownership criteria once the obligation to transfer value criterion was not met.
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