A debt-for-equity swap is a type of financial restructuring arrangement whereby an indebted company converts its outstanding debt to a creditor into equity. Within this set-up, a creditor agrees to convert the debt for equity in the debtor’s company (e.g. a borrower). The terms of the swap, including the conversion ratio (how much debt is converted into equity as well as pricing) and any other condition, are normally negotiated in advance between parties.
This type of transaction is typically undertaken when a debtor or borrower faces financial distress or constraints, and the most workable solution under certain circumstances is to convert the debt into equity. This financial strategy is used to restructure the debtor’s obligations and improve its fiscal well-being.
There are several reasons why a creditor and debtor may opt for a debt-for-equity swap, which include:-
Reducing Debt Burden: If a debtor has accumulated significant debt, it may become challenging to service them, whilst trying to meet its business obligations. By converting debt into equity, a debtor can decrease its overall debt burden, which can lead to improved cash flow and financial flexibility.
Avoiding Insolvency: When a debtor is on the verge of insolvency, a debt-for-equity swap is an option that can be used as a last resort to avoid being declared insolvent.
Investor Confidence: Debt for equity swaps can demonstrate to potential investors/creditors that the debtor is taking proactive steps to address its financial obligations and is committed not only to addressing them but also to focusing on the longevity of the business.
Investors’ Interest: In some cases, creditors may convert debt into equity to become partial owners of the debtor and enable them to influence the entity’s business strategy going forward enabling them to participate in the debtors' profitability in the long run.
What to consider during a debt-to-equity swap
Financial Situation: A creditor should first assess the financial condition of the debtor and its ability to service the existing debt before initiating a possible swap.
Communication: All stakeholders should be informed of the reasons and benefits of the swap, and there should be clear negotiation with the creditors or other parties, to reach a mutual agreement before committing to any swap arrangement.
Legal Conformity: This must be established to guarantee that the exchange aligns with applicable laws, rules, and contractual commitments. The impact of the swap on the stakeholders should be analyzed, and how it may have an impact on them, Stakeholders include employees, other shareholders, creditors, and regulators.
Types of Shares to be issued: The creditor and the debtor would have to agree on the types of shares to be issued, the rights and restrictions attached to such shares, and whether the shares will be issued at a premium, discount or market value.
Upon completion of the swap, creditors become new equity holders in the debtor, and whatever claims they have in the debtor ends, except if there are other claims not part of the swap deal. It is important to note that debt for equity swaps can have implications for existing shareholders, as their shares may be diluted if new shares are issued to the new equity holders without the existing shareholders exercising their pre-emptive rights. Additionally, the success of a debt-for-equity swap depends on the debtor’s ability to improve its financial performance and generate value for shareholders and new equity holders. Therefore, companies must carefully consider the potential benefits and drawbacks before deciding to pursue a debt-for-equity swap. Consulting with financial advisors and legal consultants is crucial in navigating such transactions' complexities.
By Linda Tongora - Advocate
Note: This is not a legal opinion, and the contents hereof are not meant to be relied upon by any recipient unless our written consent is sought and explicitly obtained in writing.
