Debt for equity swaps - guide for UK private companies

What is a debt for equity swap?

A debt for equity swap is a corporate transaction where a company exchanges its debt obligations for equity shares in the company. In simple terms, the company converts debt into shares. Debt for equity swaps have 2 main drivers, 1 based on the company doing well (where the lender exercises convertible loan rights) and the other more common scenario based on the need to restructure.

How does a debt for equity swap work?

In very basic terms the steps are :-

• Valuation - the value of the debt is assessed, and a corresponding number of equity shares is determined.

• Shares are issued - the company issues new shares to the debt holders.

• Debt cancellation - the debt is extinguished in exchange for the newly issued shares.

Is a debt for shares swap possible?

To maximise the chances of success, the following are invariably essential :-

• Timing - the company must recognise financial difficulties early and take proactive steps to restructure before reaching a point of no return.

• Creditor co-operation - rarely will the company have a right to compel the lender to agree a swap. To gain co-operation, the company may be forced to make significant concessions to creditors, potentially leading to a loss of control over the business.

• Shareholder agreement - existing shareholders will experience dilution ad potentially very significant dilution as new shares are issued to creditors. Depending on the extent of the dilution and the company's governance structure, obtaining shareholder approval may pose challenges.

• Tax - always an important consideration as there will be tax implications. Stamp duty land tax (SDLT) may be payable on the issue of shares. Capital gains tax (CGT) may arise for debt holders if the swap results in a gain. The swap may have implications for corporation tax, particularly if it involves a debt write-off.

• Valuation challenges - accurately valuing the debt and determining the appropriate share price can be complex.Getting the numbers right is critical. Independent valuers can assess both the debt value and what the company shares will be worth after conversion. This directly affects how many shares creditors receive for their debt. The process often causes tension as everyone wants the best deal.

Specific disadvantages and risks

The starting point is that even where a creditor might consider a swap, the borrower is in a weak position. As a result, as borrower you should expect :-

• Higher interest rates compared to traditional bank loans - debt for equity lenders typically charge significantly higher interest rates (often 3-5% above standard bank rates) due to the additional risk and complexity of the arrangement.

• Complex fee structures - beyond interest, lenders impose multiple fees including arrangement fees (1-3% of facility), monitoring fees (annual charge for oversight), and exit fees (percentage of total facility upon repayment).

• Early repayment penalties - substantial charges (often 2-5% of repaid amount) apply for early debt settlement, as lenders seek to protect their expected returns.

• Hidden costs in documentation - significant expenses in preparing and maintaining documentation, often requiring specialist legal and financial advice.

• Immediate ownership dilution - existing shareholders' ownership percentage decreases upon conversion, directly reducing their control and economic rights.

• Future dilution from anti-dilution provisions - lenders often require protection against future share issues, potentially causing additional dilution for existing shareholders.

• Reduction in control - decreased voting power can affect key decision-making ability and strategic control of the business.

• Impact on future funding - existing debt-equity arrangements can make future funding more expensive and complex due to diluted ownership structure.

• Borrowing restrictions - limited ability to take on additional debt without lender approval, constraining financial flexibility.

• Management changes - lenders often have rights to approve or veto senior management appointments.

• Limited flexibility - reduced ability to respond quickly to business opportunities or challenges.

Legal steps and work involved

• Board approval - board of directors must approve the debt for equity swap.

• Shareholder approval - shareholder approval may be required, particularly if the swap significantly impacts the company's capital structure.

• Share issue agreement or new shareholder agreement and possibly changes to the company's articles.

• Debt cancellation agreement - documenting the cancellation of the debt.

• Valuation - the value of the debt and the number of shares to be issued must be determined.

• Filing with Companies House - the company must file the necessary documentation with Companies House, including a return of allotment of shares.

How we can help

A debt for equity swap is a complex legal and financial transaction. It is essential to seek advice from experienced corporate lawyers to ensure compliance with all relevant laws and regulations. We can assist with:

• Planning and structuring the transaction - start talks with major creditors early. Present them with clear business case and benefits. Usually begin with the main bank, then approach others. Timing is crucial - too early creates panic, too late limits options.

• Drafting, reviewing and advising on the legal documents.

• Dealing with shareholder approvals.