A debt/equity swap is a mechanism a company utilizes for financial restructuring. It can also be viewed as a renegotiation of debt. In a debt/equity swap, a lender receives an equity interest such as shares of stock in the company in exchange for the cancellation of a company’s debt to them.
A debt/equity swap refers to a type of financial restructuring where a company offers its lender an equity interest in exchange for its debt interest in the company.
Debt/equity swaps are commonly performed in response to a company falling into severe financial distress.
Debt/equity swaps are sometimes an option offered to bondholders, with certain conditions.
Understanding Debt/Equity Swaps
Companies that make use of a debt/equity swap are typically in severe financial distress, whether from cash flow problems, business losses, or a substantial decline in revenues or income.
If it is clear to the company’s lender that the company is very unlikely to be able to repay its outstanding debt – at least not within any reasonable amount of time – then the lender may be willing to swap the debt obligation out for an equity position in the company.
However, the lender is generally only willing to make such a deal if it believes that the debt cancellation will enable the company to remain viable.
If, in contrast, the lender believes that the company is still likely to go completely under financially (bankrupt) even with the cancellation of its debt, the lender will likely see little advantage to swapping out the debt obligation for an equity interest in a failing company.
It is because, in the event of liquidation, debt holders are first in line to be paid before equity holders. Sometimes, a debt/equity swap is performed as part of a financial reorganization under a Chapter 11 bankruptcy proceeding.
Debt/Equity Swap Example
Company A just suffered an unforeseen and massive drop in revenues as a result of a sudden economic crisis. The company can probably recover financially as the crisis eases, but a significant decline in revenue created an equally severe cash flow problem. Consequently, it cannot make its scheduled payments on a $5 million outstanding loan.
To solve its cash flow crunch and survive the crisis, the company approaches its lender and offers a 20% equity interest in the company in exchange for the lender canceling the outstanding balance on the loan.
As the lender also believes that, with a bit of help, Company A can survive and return to profitability, it agrees to take the equity interest offered in exchange for repayment of the remaining loan balance. It cancels the loan and receives 20% of the company’s stock.
Advantages and Disadvantages
Like most major financial moves a company may choose to make, restructuring financially through a debt/equity swap has both advantages and disadvantages to consider.
The primary advantages are the following:
Financial survival – A debt/equity swap may offer the company the best chance of weathering financial difficulties.
Preservation of credit rating– By not defaulting on loan payments, the company can maintain its credit rating.
Lowest cost alternative – A debt/equity swap may be a company’s cheapest way to obtain needed capital.
Potential disadvantages to executing a debt/equity swap are as follows:
May not solve the problem – The company may continue to suffer financial stresses even after doing the swap.
Paying too high a price – The lender may ask for an equity interest that represents a much higher financial price than the outstanding loan balance.
Loss of equity – By giving away part of the company’s equity, the owners lose part of their interest and control in the business.
Other Types of Debt/Equity Swaps
A debt/equity swap is sometimes used by homeowners who cannot make their mortgage payments. In such a situation, the mortgage lender may be willing to refinance the mortgage for a lower amount – which also means lower payments – in exchange for an equity interest in the home whenever it is sold.
For example, the mortgage lender may reduce a $220,000 mortgage debt to only $150,000. In return, the mortgage lender will receive an agreed-upon percentage of the proceeds from the sale of the home that exceeds $150,000.
Debt/equity swaps are also often built-in options for bondholders. The option gives the bondholder the right to exchange the bond(s) it holds for a specified equity interest in the company that issued the bond(s).
The equity interest may be a specified number of shares or a number of shares equal to a certain dollar amount. Debt/equity swap options are typically limited by provisions that specify the conditions or time frame under which the option can be exercised.
For example, the bondholder may not be able to exercise the option prior to five years from the date of their bond purchase.