Debt for equity swap - overview and brief guide

Debt for equity swaps are a way for a company which is struggling financially but which remains promising and potentially viable, to restructure.

There are 3 key starting points – the company will need to be proactive at the right time, before things become financially untenable. Secondly, creditors must have faith in the business and be receptive to a debt for equity swap. Thirdly, existing shareholders will be diluted and possibly very significantly diluted by the swap. Depending on the shareholding structure, shareholder agreement and/or company articles of association, getting shareholder approval may be difficult.

Risks for the company from an inherently weak negotiating position can often lead to making very significant concessions which in turn can lead to loss of control of the business and possibly the directors taking on personal liabilities going forward.

In almost all cases converting debt to equity will involve a significant amount of legal work the cost of which will also need to be considered (including can it be funded and if so, how) and balanced against the benefits.

Why would a creditor agree to a debt for equity swap?

A creditor will put it's commercial interests first so will need to believe there are good future prospects for the company, that it is suffering from a short term blip and that there are commercial benefits. The second main reason creditors may agree is to avoid having to take action to enforce security which can in turn lead to the company imploding which in turn may mean that the creditor may not recover all monies due if the company becomes fully insolvent.

Likely demands from creditors to agree a debt for equity swap

• How much debt will be converted to equity? - if not the full amount will the creditor demand revised and more advantageous terms for the remaining debt, which may include new security or personal guarantees from directors. Creditors may also demand veto rights, drag and tag along rights or different classes of shares with enhanced rights or a controlling interest in the company so that they can control or block ordinary resolutions.
• What is the position with other creditors? - this will be key for the creditor who will not want to give up some or all of it’s security for equity only to find other creditors pursue the company possibly leading to insolvency.
• Existing shareholder debt – lenders may well demand that directors and/or shareholders agree to write off existing loans from them to the company.
• Tax considerations.

Potential negotiating points for the borrower company

The company will generally be in a  weak negotiating position so should generally focus on key and possibly attainable concessions. Often the most important are to try and avoid personal guarantees, to retain some form of control and also to agree that during negotiations, the lender will not take any action against the company. Other priorities for the borrower typically include :-

• Realistic new financial covenants – with likely reduced control by existing directors and shareholders it is important to negotiate realistic financial performance covenants. If there is a partial debt for equity swap it will be important to consider building is some flexibility for contingencies such as potential payment holidays.
• Standstill agreement – to ensure that whilst negotiations over the debt for equity swap continue the lender agrees to take no steps to call in or enforce the loan.

Legal issues and work required

There will be a considerable amount of legal work needed with any debt for equity swap. Depending on what’s agreed this can include :-

• A debt for equity swap agreement will need to be drafted.
• Formal amendments to existing loan and other agreements plus potential amendments to articles of associations and/or shareholders agreement.
• Obtaining consents from minority shareholders, possibly other lenders and potentially even counterparties in important contracts where there are Change Control provisions in the contract.
• Formalities for allotting new shares - is this covered and permitted by the company’s articles? The simplest way will often be an ordinary resolution by shareholders.
• Implications for management or employee incentives – what impact, legally and otherwise will the proposed dilution have on shares and share options?.
• Regulatory - If the business is regulated, formal consent may well be required.
• Tax considerations.

How we can help

We are experienced in advising on debt for equity swaps and options generally for private companies facing financial and other problems. We always look for the most practical and cost effective solution. Please do get in contact to discuss and find out the best option for you,