What Are Non-Marketable Securities? Definition, Types, and Examples

Non-marketable securities represent a category of financial assets that cannot be easily bought or sold on public exchanges. These instruments are often held for specific purposes and can contribute to the diversification of an investment portfolio, offering stability during market fluctuations.

Understanding non-marketable securities is essential for investors aiming to enhance their financial strategies while navigating the complexities of asset management.

Qualifying Criteria

Non-marketable securities are defined by their lack of liquidity, meaning they cannot be readily converted into cash without a significant loss in value. This illiquidity stems from the absence of a public market where these securities can be traded, making them less accessible to the average investor.

The ownership structure of these securities often involves private agreements or specific conditions that restrict transferability. For example, government savings bonds can only be redeemed by the original purchaser or designated beneficiaries, ensuring control over their ownership. Regulatory frameworks, such as the Securities Act of 1933, also influence the marketability of certain securities by imposing registration requirements or exemptions. Private equity ownership, another form of non-marketable security, must comply with regulations like the Investment Company Act of 1940, which governs the operations of investment companies.

Types of Non-Marketable Assets

Non-marketable assets include various financial instruments that are not easily traded on public exchanges. These assets are often held for their potential to provide stable returns and diversification benefits.

Government Savings Bonds

Government savings bonds, issued by the government to raise funds, are low-risk investments. They are non-transferable and cannot be traded in secondary markets. The U.S. Treasury offers Series EE and Series I bonds, which differ in their interest structures. Series EE bonds earn a fixed interest rate, while Series I bonds combine a fixed rate with an inflation-adjusted rate. Interest earned on these bonds is subject to federal income tax but exempt from state and local taxes under the Internal Revenue Code (IRC) Section 135. Investors must adhere to a minimum one-year holding period and may face a penalty of three months’ interest if redeemed before five years.

Restricted Stock

Restricted stock refers to shares granted to employees or executives as part of their compensation, subject to restrictions like performance goals or vesting periods. These shares are non-marketable until the restrictions lapse. Under the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 718, companies must recognize the fair value of restricted stock as compensation expense over the vesting period. For tax purposes, recipients may elect to be taxed at the grant date under IRC Section 83(b), which can reduce their tax liability if the stock appreciates. However, this election carries risks, as taxes are due even if the stock’s value decreases or vesting conditions are not met.

Private Equity Ownership

Private equity ownership involves investments in private companies that are not listed on public exchanges. These investments, often made by private equity firms or venture capitalists, are non-marketable due to their illiquid nature and long investment horizons, which can span several years. Valuation of private equity holdings requires adherence to fair value measurement principles under International Financial Reporting Standards (IFRS) 13 or FASB ASC Topic 820. Metrics like Internal Rate of Return (IRR) and Multiple on Invested Capital (MOIC) are used to assess performance. Regulatory requirements, such as those in the Dodd-Frank Wall Street Reform and Consumer Protection Act, mandate registration and reporting for certain private fund advisers.

Transfer Restrictions

Transfer restrictions are a defining characteristic of non-marketable securities, influencing their valuation, liquidity, and appeal. These constraints arise from legal, contractual, or regulatory frameworks. In private equity, transfer restrictions are often detailed in partnership or shareholder agreements, which may include conditions like rights of first refusal or co-sale rights.

Restricted stock units (RSUs) and employee stock options also feature transfer restrictions, governed by vesting schedules and performance criteria. These restrictions incentivize employees to achieve long-term goals and aid in talent retention. The accounting treatment for stock-based compensation under FASB ASC Topic 718 requires recognizing the fair value over the vesting period.

From a regulatory standpoint, the Securities and Exchange Commission (SEC) enforces Rule 144, which governs the sale of restricted and control securities. Rule 144 specifies conditions such as a minimum holding period, volume limitations, and the requirement for adequate public information about the issuer.

Accounting Considerations

Non-marketable securities pose unique accounting challenges due to their illiquid nature and valuation complexities. Determining fair value in the absence of active market prices is a primary consideration. Under Generally Accepted Accounting Principles (GAAP), entities use valuation techniques outlined in FASB ASC Topic 820, including income, market, or cost approaches, each requiring careful assumptions and methodologies.

Transparent financial reporting is critical for these securities. Companies must disclose valuation methods, key assumptions, and any changes to them in their financial statements. They must also identify the level of input hierarchy—Level 1, 2, or 3—used in the valuation process, as mandated by FASB.

Valuation

Valuing non-marketable securities requires specialized methodologies due to the absence of observable market prices. This often involves using Level 3 inputs under FASB ASC Topic 820, relying on unobservable data and significant management judgment. The valuation approach selected depends on the security type and the availability of relevant information.

The income approach is commonly used, particularly for private equity or restricted stock. This method estimates the present value of expected future cash flows, discounted at a rate reflecting the asset’s risk profile. For private equity, analysts may use the Weighted Average Cost of Capital (WACC) as the discount rate. Adjustments for illiquidity, such as the Discount for Lack of Marketability (DLOM), are often applied, typically ranging from 10% to 30% based on holding period restrictions and market conditions.

Alternatively, the market approach can be employed when comparable transactions or companies exist. This involves deriving valuation multiples—like Price-to-Earnings (P/E) or Enterprise Value-to-EBITDA (EV/EBITDA)—from similar entities and applying them to the asset. Adjustments may be necessary to account for differences in size, growth prospects, and risk.

Tax Treatment

The tax implications of non-marketable securities depend on the security type, holding period, and transactions involved. For government savings bonds, interest income from Series EE or Series I bonds is subject to federal income tax but exempt from state and local taxes. Investors can defer reporting interest income until redemption or maturity, as allowed under IRC Section 454. Interest may also be excluded from federal income tax if used for qualified education expenses, provided income limits under IRC Section 135 are met.

Private equity investments and restricted stock involve more complex tax scenarios. Gains from private equity are usually taxed as long-term capital gains if held for more than one year, with a maximum federal rate of 20%. For restricted stock, taxation depends on whether the recipient makes an IRC Section 83(b) election. Without the election, taxation occurs upon vesting, based on the stock’s fair market value. If the election is made, taxation happens at the grant date, potentially lowering the tax burden if the stock appreciates during the vesting period.