What Happens When a Loan Converts to Equity?

As a director of a private company, it is not uncommon to take out loans to finance your business. 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 you 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. 

What is Debt-For-Equity?

Debt represents an amount of money that your company must repay in the future, usually with interest. Equity is a measure of ownership in a company. Most companies grow by issuing a mixture of debt and equity financing. 

In some cases, your company may have borrowed money containing a provision that allows the lender to “swap” the debt for equity. Alternatively, the lender may approach your company and ask 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 ownership in your company (i.e. equity). 

Likewise, your company will award equity in the form of shares. However, the lender will often be issued shares of a different class (e.g. preference shares). This can often happen in the context of restructuring or refinancing, for instance, if your company is having a hard time making its payments. 

Other 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:

• how much debt will you agree to swap for equity; 
• the proportion of total equity in your company the lender will obtain; 
• what rights will 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 the position of you and the lender. 

Discharging the Loan 

Your company and the lender 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; 
• if the shares will be issued at par or a premium amount; and 
• that the lender accepts the shares as full 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, then shares are allotted by an ordinary resolution of the shareholders; 
• 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 own special class of shares. Such shares are commonly called “preference shares” because it gives lenders preferential treatment over other classes of shareholders. Most commonly, such preference shares will stipulate:

• a superior right to a return on capital; and 
• the right to dividends paid at a fixed amount. 

Additional, 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.

This means that your lender can exercise the right to redemption after a set period or upon the happening of some event. Accordingly, your company will pay a specified amount per share back to the lender. 

The effect is similar to being repaid the principal sum of a loan. The only difference is that redemption rights can specify a repayment amount above the price of the shares at the time they were issued. For this reason, swapping debt for equity can be advantageous to the lender if they think the underlying value of the company 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 certain 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. 

Pre-Pack Administration

For more complex restructurings, you may agree with the lender to create a new company, which will acquire your existing business. The lender will then acquire shares (and likely issue some amount of debt) to the new company. Notably, this process can become quite detailed and complex. Therefore, it is best to engage professional advice before choosing this option. 

Other Considerations 

Amending Your Company Articles 

In many cases, you may need to first amend your company articles. 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 large losses when companies go through financial difficulty and pursue debt-for-equity swaps. Likewise, there can be significant tax implications depending 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 its advantages and disadvantages. If your company is having a hard time meeting its financial obligations, a debt-for-equity swap is usually preferable to having to initiate insolvency proceedings. However, the shareholders in your company will likely lose a portion of their equity unless your company gives them the option 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 common shareholders. On the other hand, this means they will get preferential rights to dividend payments and the return of their capital. 

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.

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