What Happens When a Loan Converts to Equity?

As a private company director, taking out loans to finance your business is not uncommon. However, it can be confusing if your company’s lender approaches you to convert the outstanding loan amount to equity. Or maybe, instead, as part of the loan agreement, there may be a provision that permits the company or the lender to convert the debt to equity. This article will explain the implications behind converting debt to equity. It will then discuss important considerations, like how preference shares usually operate in a debt-for-equity swap. 

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What is Debt-For-Equity?

Debt represents the amount your company must repay in the future, usually with interest. Equity is a measure of ownership represented by shares issued in the company. Most companies grow by issuing a mixture of debt and equity financing, with both forms of financing having their pros and cons. 

In some cases, your company may have borrowed money through a loan instrument that contains a provision allowing the lender to “swap” the debt for equity. Alternatively, the lender may ask your company to convert the loan amount to equity. Finally, you may even approach your company’s lender and see if they would be willing to swap the outstanding debt for equity. 

Regardless, if your company’s debt is swapped for equity, a portion of the debt will be written off in exchange for a corresponding amount of shares in your company (i.e. equity). 

The lender will often be issued different class shares (e.g. preference shares). This can often happen in the context of restructuring or refinancing, for instance, if your company is in financial stress and failing to pay its debts. 

Primary Considerations 

The primary commercial considerations that you will need to work out with your lender when it comes to swapping your debt for equity include the following:

• how much debt you will agree to swap for equity; 
• the proportion of total equity in your company the lender will obtain; 
• what rights your company attach to the newly-issued shares; and 
• if there will be any limitations on the lender’s right to sell the shares to a third party. 

In some cases, the terms of the loan will specify these questions. But in other cases, this is a matter of negotiation based on your position and the lender’s. If you are open to your lender exchanging debt for equity in the future, it may be advantageous to negotiate this when you agree on the loan terms. If you wait till your company is in financial stress and approach the lender to request a debt for equity exchange, your bargaining position will be much weaker, and you may need to agree to less favourable terms.

Discharging the Loan 

If you do not have a convertible note with the lender and the company and the lender have agreed to swap the debt for equity, then you will need to document an agreement with the following information:

• the amount of the loan to be discharged; 
• the number of shares and their nominal value to be issued to the lender;
• any rights attached to the shares; 
• if the shares will be issued at nominal value or a premium amount; and 
• that the lender accepts the shares as satisfaction of the loan. 

In practice, you should execute this agreement as a “deed of release.” This is simply a more formal way of recording this agreement. 

Process of Swapping Debt for Equity 

In the simplest of swaps, the process is fundamentally no different than issuing new shares:

• shares are allotted either by the directors’ powers to do so. Alternatively, if they do not have this power, then shares are usually allotted by an ordinary resolution of the shareholders;
• if required, the companies’ articles of association may need to be amended to create a new class of shares to be held by the lender; 
• if required, shareholders agree to waive their “preemption rights”, i.e. the right to maintain the same proportion of equity ownership; 
• directors will convene a meeting to approve the terms of the share issue. Likewise, they will need to approve the agreement with the lender; and
• Form SH01 is completed and returned to Companies House.

Preference Shares

In many cases, the lender will want their special class of shares. Such shares are commonly called “preference shares” because they give lenders preferential treatment over other classes of shareholders. Most commonly, such preference shares will stipulate:

• a superior right to a return on capital if the company is liquidated; and/or 
• the right to dividends paid at a fixed amount. 

Additionally, from your lenders’ perspective, they will want the class of shares issued to them to behave like the initial loan. Your company can achieve this by negotiating certain redemption rights and dividends. 

Redemption Rights

The mechanics of how share redemptions operate are beyond the scope of this article. But in general, redemption rights in shares give the relevant class of shareholders the right to “redeem” their shares for cash.

The effect is similar to being repaid the principal sum of a loan. Redemption rights can specify a repayment amount higher than the original share price. For this reason, swapping debt for equity can be advantageous to the lender if they think the company’s underlying value will increase over time. 

Dividends 

It is common for the preference shares to give the lender the right to dividend payments at a fixed rate. You may notice the effect is similar to interest payments: i.e. the lender will receive a fixed amount over a specific period. 

However, dividends differ from interest payments in one critical way. Importantly, your company cannot issue dividends unless it has made a profit. Therefore, compared to debt, this is advantageous to your company because there is no obligation to make a payment unless your company is doing well enough to turn a profit. 

Keep in mind that parties may negotiate rights attached to the preference shares so that the dividend rights are “cumulative.” Cumulative dividend rights mean that at the first chance your company can declare a dividend, that the dividends that your company should have paid over a period of time, it pays at once. 

Other Considerations 

Amending Your Company Articles 

In many cases, you may need to first amend your company articles to create the new class of shares to be held by the lender. Following this, you can meet the terms of the agreement with the lender for the debt-for-equity swap. Therefore, you should always check the articles. Importantly, ensure that you do not do anything as a director that exceeds the limits of your powers. 

Tax and Accounting 

Usually, there are significant losses when companies go through financial difficulty and pursue debt-for-equity swaps. Likewise, significant tax implications can depend on how your company issues and capitalises new shares. Additionally, there may be impacts on your company’s capital adequacy. You should, therefore, consult with a qualified accountant. 

Key Takeaways 

Swapping the debt your company owes to a lender for equity has advantages and disadvantages. If your company is having difficulty meeting its financial obligations, a debt-for-equity swap is usually preferable to initiating insolvency proceedings. However, the shareholders in your company will likely see their shareholding diluted unless your company allows them to invest further (which some lenders may require). Additionally, you may lose out on receiving a share of your company’s profits in the long run. This is because, as a general rule, the shares issued to your lender will rank above the shares held by the ordinary shareholders.

If you need help navigating how to swap the debt your company owes a lender for equity, our experienced corporate lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today at 0808 196 8584 or visit our membership page.

Frequently Asked Questions

How do I initiate a debt-for-equity swap?

A debt-for-equity swap is a type of agreement between your company and your lender. Here, in exchange for writing off a portion of your debt, the lender obtains a share of ownership in the company. Therefore, if you can agree with your lender and the company’s shareholders approve, you will need to issue shares per your company’s articles of association. Complying with this document is vital to ensure you observe your duties as a director. 

What are the advantages and disadvantages of a debt-for-equity swap?

The exact terms of a debt-for-equity swap depend on your company’s and your lender’s position. Generally, it is an alternative way for a lender to recover the value of a loan made to your company without initiating insolvency proceedings against your company. As a business owner, this is preferable because it means your company may avoid liquidation. However, the downside is that you will lose a degree of ownership in your company, and your lender will now become a shareholder.