How Does Debt-for-Equity Swap Work?
In a debt-for-equity swap, the creditor converts a loan amount or the loan amount represented by outstanding bonds into equity shares, thereby transforming debt into equity. No actual cash is exchanged in the debt-for-equity swap process.
Shares represent the money invested in the company by owners known as shareholders. A shareholder typically receives voting rights and can vote at annual meetings pertaining to the management of the company or the next steps.
The shareholder receives cash flow from dividends they own if the company distributes profits. The shareholder may make a profit, incur a loss, or earn nothing on the original capital they invested when they sell their shares.
Note: Equity in the company is calculated by subtracting the total value of liabilities from the total value of assets. The net worth of the company represents its equity or what it owns minus what it owes.
A debt-for-equity swap usually occurs when the company faces some financial difficulties. Making payments on its liabilities is typically challenging. Immediate corrective action during these tough times is necessary to regain some financial stability, so the company may seek to improve cash flow by converting debt into equity.
Note: A debt-for-equity swap can also occur when the company files for bankruptcy, as a result of bankruptcy proceedings. In most cases, the process is the same.
Examples of Debt-for-Equity Swap
Let’s take a look at an example of what a debt-for-equity swap is and how it works. Suppose Company A owes lender K an amount of $10 million. Instead of continuing payments on this debt, Company A may agree to give lender K $1 million or a 10% equity stake in the company in exchange for wiping out the debt.
In the case of bankruptcy, if Company A cannot make payments on the debt owed to lender K, the lender could receive an equity stake in Company A in exchange for settling or canceling the debt. However, the swap is subject to approval by the bankruptcy court.
If Company A files for Chapter 7 bankruptcy, it settles all its assets to pay creditors and shareholders. Since the business stops when this occurs, it will no longer have any debts and thus will not participate in a debt-for-equity swap.
In the case of Chapter 11 bankruptcy, Company A will continue to operate and focus on reorganizing and restructuring its debts. A debt-for-equity swap in Chapter 11 involves first canceling the existing equity shares of Company A. After that, it must issue new equity shares. Then it exchanges these new shares for the existing debt held by bondholders and other creditors.
Note: The finance department of the company records journal entries on the transaction date to account for the debt-for-equity swap.
When recording a $10 million loan conversion into equity, the company can record the full loan amount of $10 million in its accounting books, even if the swap is valued at $1 million or a 10% equity stake, as in the above example. The ordinary equity account records this new stake – $1 million or 10%. The finance department of the company must also deduct interest expenses to report any losses incurred from converting debt equity.
Note: A debt-for-equity swap may also be referred to as a debt conversion or debt exchange.
Frequently Asked Questions (FAQs)
What is the formula used in a debt-for-equity swap?
Equity in the company is calculated by subtracting the value of total liabilities from the value of total assets. A company’s debt is simply the debt it owes to lenders, etc. The formula is simply an agreement to exchange a certain amount of debt for a certain amount of equity. For example, $10 million of debt can be swapped for $1 million or a 10% equity stake.
How much
How long does it take for a company to swap debt for equity?
The time it takes for a company to complete a debt-to-equity swap depends on the unique financial situation it faces. For instance, if the company is in bankruptcy and requires approval from the bankruptcy court, the timeline will depend on the court’s schedule.
Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and keep our content accurate, reliable, and trustworthy.
Sources:
IRS. “Equity (Stock) – Based Compensation Audit Techniques Guide (August 2015).”
FINRA. “How Companies Use Their Cash: Dividends.”
U.S. Department of Agriculture. “Managing Your Cooperative’s Equity.”
Jaka Cepec & Peter Grajzl. (2020). “Debt-to-Equity Conversion in Bankruptcy Reorganization and Post-Bankruptcy Firm Survival.” International Review of Law and Economics, 61.
IRS. “Chapter 7 Bankruptcy–Liquidation Under the Bankruptcy Code.”
United States Bankruptcy Court, Northern District of California. “What Is the Difference Between Bankruptcy Cases Filed Under Chapters 7, 11, 12, and 13?”
U.S. Agency for International Development. “Basic Guide To Using Debt Conversions.”
Source: https://www.thebalancemoney.com/what-is-a-debt-to-equity-swap-1290541
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