Ownership Interest Value
In addition to the more straightforward analysis of Voting Power as a determinant of the beneficial ownership reporting threshold, an entity must independently evaluate the amount of Ownership Interest Value held by all individuals, as a percentage of the total value of the reporting entity.
Of course, the first step in this process is to identify the total value of the reporting entity. In the event that the entity has been through a recent formal valuation process, the total value of the entity is likely to be satisfactorily established by the determinations made in that process. Unfortunately, in the absence of such a formal valuation of the entity, it is not entirely clear how total Ownership Interest Value (OIV) is to be calculated. While some entities establish “book” or “par” value of their ownership interests in their organizing documents, this assignment is unlikely to be accepted as the true value for the entity for purposes of reporting. Instead, it appears much more likely that the salient value for reporting purposes is the fair market value (“FMV”) of the entity.
FMV may be established in a number of ways, with each method liable to achieve different results. For instance, one valuation method often employed to determine FMV is based on the entity’s income stream. With this method, the entity’s average yearly profit is used to determine the price that a third-party might pay to acquire that income stream. A separate method, which is also quite common, would be to establish a liquidation value for the entity. The liquidation value is derived by assessing the total amount that would be realized by ceasing the business activity of the entity and selling all of its assets. Whatever method is utilized to determine the total value of the entity, that value is then used to calculate the Ownership Interest Value ascribed to each individual that holds an interest in the entity.
Each individual’s OIV is related to that individual’s proportional entitlement to the total FMV of the entity. In the most basic setup, it is easy to assess each individual’s OIV by simply multiplying the FMV of the entity by the individual’s proportional share of ownership in the entity. Things become more complicated, however, when there are different classes of owners entitled to differing portions of the entity’s profits, when there are Options or contingent rights to obtain additional ownership in the entity, and/or when there is Indirect Ownership of the entity.
In the case of multiple classes of owners, the calculation of fractional shares may be more complicated. For example:
Company A is worth $2M and has two classes of stock. There are fifty (50) shares of Class A stock, with each share entitled to 1% of the profits of the entity. In addition, there are one hundred (100) shares of Class B stock, with each share entitled to 0.5% of the profits of the entity. Allen owns twenty-five (25) shares of Class A stock and Betty owns twenty-five (25) shares of Class B stock. In this example the value of Allen’s stock in Company A, as established by his entitlement to 25% of the profits of Company A (twenty-five (25) shares of Class A stock x 1% of profits per share = 25% of the value of Company A) is $500k ($2M x 25% = $500k). Allen’s $500k value is 25% of the value of the FMV of Company A ($500k/$2M = 25%), meaning Allen’s beneficial interest must be reported. On the other hand, Betty is entitled to only 12.5% of Company A’s profits (25 shares of Class B stock x 0.5% per share = 12.5% of profits), making her interest worth $250k ($2M x 12.5% = $250k). Betty’s $250k value is 12.5% of the value of the FMV of Company A ($250k/$2M = 12.5%), meaning Betty’s beneficial interest is below the reporting threshold. Obviously, this example is made easier by the numbers chosen for the illustration, but a real-life calculation is not at likely to use such round numbers and may be far more complicated.
Indirect Ownership may cause additional complications. Indirect Ownership occurs when some portion of the reporting entity is owned by another entity, as opposed to simply being owned by individuals. When this happens, one must assess the proportional ownership of these sub-entities, as well. For example:
Company A has a value of $1M and has issued 100 shares of stock. Fifty (50) shares are owned by individuals, and each has their OIV calculated as described above. The remaining fifty (50) shares are owned by Company B, meaning the owners of Company B have Indirect Ownership in Company A. First, it is elementary that Company B’s total OIV in Company A is $500k ($1M x 50% ownership = $500k). Next, the fractional ownership of Company B will control the OIV ascribed to the Indirect Ownership of Company A, which will determine which, if any, of those owners must report. In this example, Company B has also issued 100 shares of stock, but no individual owns more than five (5) shares of Company B stock. Allen, who is the largest Company B shareholder, owns five (5) shares of Company B. To determine the OIV of Allen’s Indirect Ownership in Company A, we need to calculate the proportion of Company B’s total OIV to ascribe to him. Allen’s five (5) shares, of the 100 outstanding shares of Company B, comprise 5% of Company B’s ownership. This means that the OIV of Allen’s Indirect Ownership of Company A is valued at $25k ($500k (total OIV of Company B’s interest in Company A) x 5% (Allen’s proportional ownership of Company B) = $25k). The final step is to assess how the OIV of Allen’s Indirect Ownership of Company A ($25k) measures up against the total FMV of Company A ($1M). This calculation reveals that the OIV of Allen’s Indirect Ownership of Company A is merely 2.5% of Company’s A’s FMV ($25k/$1M = 2.5%), and his interest in Company A is below the reporting threshold.
Finally, as with all of these calculations, all Options, or other contingent ownership interests, must be included as if they were exercised. In the real world, such Options have fair market value of their own, but this value is discarded for the purpose of determining beneficial ownership. An example will again illustrate this situation, as well as the potentially strange consequences of applying the reporting rules:
Company A, which has been valued at $1M, has issued fifty (50) shares of stock and has also issued options to purchase an additional fifty (50) shares for $10k/share. Allen owns thirty shares of Company A stock, while Betty has Options to purchase thirty (30) shares of Company A stock. Since the fifty (50) Options must be treated as having been exercised, Company A’s total FMV per share (whether an actual share or simply an Option) is $10k ($1M FMV ÷ 100 shares = $10k/share). Accordingly, the OIV of Allen’s thirty (30) shares is $300k (30 shares x $10k/each), which is 30% of the total FMV of Company A, and his interest must be reported. Somewhat strangely, the OIV of Betty’s Options is also $300k (30 Options x $10k/each), which is 30% of the FMV of Company A, and her interest must also be reported. The strangeness comes from the fact that Betty would actually have to pay out $300k to exercise her Options and acquire the thirty (30) shares of Company A stock, which are themselves only worth the same $300k, seemingly indicating a “wash” for Betty. This is, however, of no consequence for the purpose of reporting beneficial ownership.
In the end, given the myriad ways that beneficial ownership is defined, nearly every kind of significant ownership interest in a reporting entity is likely to result in a need to report. Nonetheless, to determine whether such reporting is indeed required, a reporting entity must assess the Ownership Interest Value attributable to all individuals, including those individuals with Indirect Ownership and/or owners of contingent interests, like Options.
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