FASB Issues Proposed Guidance on Discounts for Lack of Marketability
On September 15, the FASB proposed potential improvements to fair value guidance for equity securities regarding discounts for lack of marketability, or DLOMs. This specific proposal and request for feedback is related to the impact of contractual restrictions on the fair value of an equity security, and operates through removing discounts based on contractual restrictions from the unit of account.
A unit of account is a financial asset (asset, liability, group of assets, etc.), to which recognition criteria and measurement concepts are applied. The FASB wanted to clarify that contractual restrictions on sale of public securities should not be considered as part of the unit. As a result, if the FASB moves forward with this proposal, marketability discounts would no longer be considered in measuring the fair value of certain investments.
This guidance is interesting and potentially contradictory to how restricted equity securities have been looked at in the past. Typically, there is a discount associated with restricted shares, and there is ample academic evidence that restricted shares sell for less than readily tradable ones. For fair value recognition, this is typically estimated using a DLOM.
A DLOM is meant to reflect that an asset holder cannot sell the underlying security. For instance, if you hold a share of stock in IBM, there is an active market where you can sell it today. Now, let’s assume that I buy a share of IBM stock, except the holder has an agreement where it has pledged to not sell the stock for two years. Such a transaction may be from a private investment in public equity, or PIPE, transaction. Alternatively, I may receive shares of a company for which I have agreed not to sell until six months following the IPO—a so-called lock-up. The share is “worth” the same as the public IBM share in terms of future cash flows, but I contractually cannot sell it. For all I know, the share could drop in value until I can sell it. How do we reflect this when valuing the share of the restricted stock?
In considering the value of this restriction, a holder may consider the price to “insure” the price of that private share until it can be sold. it is most common to use the cost of put options (which offer the right to sell an asset at a particular price in the future) to act as the effective insurance contract, based on insuring either the starting or average value of the stock to determine a discount. These models tend to be consistent with actual discounts seen in the marketplace.
Part of the reason this guidance from the FASB is so intriguing is that it has implications for the application of DLOMs. Let’s consider a hypothetical: ABC Corp, a public entity, decides to issue two similar equity instruments. The first can be bought and sold without restriction. The second, however, is under contractual obligation to not be sold for two years. It’s almost certain that the second security sold for less than the first due to the sales restriction. That said, this new guidance could result in an immediate gain to the holder if that discount isn’t recognized. On the other hand, we may see a move to shares that are unregistered, therefore creating a more formal difference between the two shares. It’s also unclear whether this could create divergences with tax, where a hypothetical sale would include all restrictions.
In considering this potential rule change, it makes sense to pay attention to two places that would not be affected, as this may signal future movements. First, the guidance appears to affect only the private holdings in otherwise public securities. That means in most cases the DLOM still applies to private shares where there is no market, so the discount is still a critical part of the value. Further, ASC 718 currently allows DLOMs for contractual post-vest holding periods. Although ASC 718 is scoped out of ASC 820, we believe it’s unlikely that the FASB would continue to have different treatment for what effectively is the same principle.
The new FASB guidance poses some interesting questions, with answers that likely won’t exist for some time. Reaction to this proposal has been mixed and merits further clarification from the FASB. How far this proposal reaches, and the impact it will have on the future of valuation, is yet to be seen.