Why Investing Companies Care About 20% Voting Power Threshold in Portfolio Companies

If a company/venture capital firm/other fund invests in another firm, whether it's for certain strategic purposes or for a return on investment, that investment must be accounted for on the investing firm’s balance sheet. Accounting rules dictate the method to use to report the investment. Either the cost method and the equity method applies when your ownership interest in the other company is less than a controlling financial interest (more than 50% of the investee’s equity).

Presumption of Ability to Exercise Significant Influence at 20% Voting Power – may be overcome based on facts and circumstances

A stock investment in a corporate entity (portfolio company) that results in an ownership of 20% or greater of the portfolio company’s outstanding shares of voting stock leads to a presumption that the investor has the ability to exercise significant influence over the portfolio company, in which case the investor must apply the “equity method” of accounting to the investment. With the equity method, the balance sheet value of the investment changes according to the net income (the profit) of the portfolio company and report the gain as revenue on your income statement. For example, if the portfolio company had a net loss in a fiscal year, the investor would decrease the value of the investment by its share of the loss (pro rata) on the balance sheet and report the decline as an expense on its income statement. On the other hand, if the portfolio company had a net income in a fiscal year, the investor would increase the value of the investment by its share of the income (pro rata) on its balance sheet and report the gain as revenue on its income statement. Dividends from the investment are considered a return on invested capital, not revenue. The investor would decrease the value of the investment by the amount of any dividends received.

The equity method may be required for investments in certain types of entities at much lower ownership levels than 20%. For example, investments in LP, LLC, trust or other structures that maintain specific ownership accounts are accounted for using the equity method when the investor has an ownership interest of 3% to 5% or greater.

Presumption of Passive Investment at less than 20% Voting Power – may be overcome based on facts and circumstances

A stock investment in a corporate entity (portfolio company) that results in an ownership of less than 20% of the portfolio company’s outstanding shares of voting stock leads to a presumption that the investment is passive investment, in which case either cost (ASC-325-20) or fair value (ASC 320) method applies based upon the nature of the investment.

ASC 320-10-20

Equity Security

“Any security representing an ownership interest in an entity (e.g., common, preferred, or other capital stock) or the right to acquire (e.g., warrants, rights and call options) or dispose of (e.g., put options) an ownership interest in an entity at fixed or determinable prices.” The term, equity security, does not include the following:

·         Written equity options (because they represent obligations of the writer, not investments)

·         Cash-settled options on equity securities or options on equity-based indexes (because those instruments do not represent ownership interest in an entity)

·         Convertible debt or preferred stock that by its terms either must be redeemed by the issuer or is redeemable at the option of the investor