Debt for equity swap - overview and brief guide

Debt for equity swaps can provide a restructuring option for companies that are experiencing financial difficulties but remain promising and potentially viable.

There are three key starting points. First, the company needs to be proactive and consider a restructuring before its financial position becomes untenable. Secondly, creditors must have sufficient confidence in the business and be receptive to a debt for equity swap. Thirdly, existing shareholders will be diluted and may be significantly diluted by the swap. Depending on the shareholding structure, shareholders’ agreement and/or articles of association, obtaining the necessary shareholder approval may be difficult.

A company that is in a weak negotiating position may have to make significant concessions. These can lead to a loss of control over the business and, potentially, personal liabilities for directors going forward.

In almost all cases, converting debt to equity involves significant legal work and associated costs. These costs need to be considered, including whether and how they can be funded, and balanced against the potential benefits of the restructuring.

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

A creditor will put its commercial interests first and will need to believe that the company has good future prospects, that its financial difficulties may be temporary and that there are sufficient commercial benefits to restructuring the debt.

Another key reason for agreeing to a debt for equity swap may be to avoid enforcing security. Enforcement could cause the company to fail or enter insolvency, potentially reducing the amount the creditor ultimately recovers.

Likely demands from creditors to agree a debt for equity swap

Creditors may seek significant protections in return for converting debt into equity. These can include:

• How much debt will be converted to equity? - If the full amount is not converted, the creditor may demand revised and more advantageous terms for the remaining debt, including new security or personal guarantees from directors. Creditors may also seek veto rights, drag-along and tag-along rights, different share classes with enhanced rights or a controlling interest.
• What is the position with other creditors? - This will be important where the creditor is giving up some or all of its security in exchange for equity, particularly if other creditors could take enforcement action and potentially push the company into insolvency.
• Existing shareholder debt – lenders may require directors and/or shareholders to write off or subordinate loans they have made 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, achievable concessions. Important priorities can include avoiding personal guarantees, retaining some control over the business and agreeing that the lender will not take enforcement action while negotiations continue.

Other priorities for the borrower typically include :-

• Realistic new financial covenants – here existing directors and shareholders have reduced control, it is important to negotiate financial performance covenants that are achievable. Where only part of the debt is converted, the company should also consider flexibility for contingencies such as potential payment holidays.
• Standstill agreement –this can ensure that, while negotiations continue, the lender agrees not to call in or enforce the loan.

Legal issues and work required

A debt for equity swap can involve considerable legal work. Depending on the agreed structure, this may include:

• Drafting a debt for equity swap agreement
• Amending existing loan and other agreements, together with the articles of association and/or shareholders’ agreement where necessary.
• Obtaining consents from minority shareholders, other lenders and potentially counterparties to important contracts containing change of control provisions.
• Dealing with the formalities for allotting new shares, including checking whether the proposed allotment is permitted by the company’s articles and whether shareholder approval, pre-emption rights or other corporate formalities apply.
• Considering the impact on management and employee incentive arrangements, including the effect of dilution on existing shares and share options.
• Obtaining regulatory consents where the business operates in a regulated sector.
• Considering the tax implications of the transaction.

How we can help

We are experienced in advising private companies on debt for equity swaps and other restructuring options. We provide practical advice on structuring the transaction, negotiating terms and putting the necessary documentation and consents in place.

Contact us to discuss your options and the best approach for your business.