Equity is money that is invested in a company by owners who are called shareholders. A shareholder usually receives voting rights and can vote in annual meetings that concern the company’s management or next steps. A shareholder receives cash flow from the equity they own if the company pays dividends. The shareholder might earn a profit, suffer a loss, or earn nothing on the original capital they invested if/when they sell their equity. A debt-to-equity swap most commonly happens when a company is going through some financial difficulties. That usually makes it hard to make payments on its debt obligations. An immediate fix to these hard times is necessary to restore some financial stability, so a company might want to improve its cash flow by converting debt to equity.
Examples of Debt-to-Equity Swaps
Let’s look at an example of what a debt-to-equity swap is and how it works. Let’s say Corporation A owes Lender Q $10 million. Instead of continuing to make payments on this debt, Corporation A might agree to give Lender Q $1 million or a 10% ownership share in the company in exchange for erasing the debt. In the case of bankruptcy, if Corporation A can’t make the payments on the debt owed to Lender Q, the lender could receive equity in Corporation A in exchange for the debt being discharged or eliminated. However, the exchange would be subject to the approval of the bankruptcy court. If Corporation A files Chapter 7 bankruptcy, it liquidates all of its assets to repay creditors and shareholders. Since the business ceases to exist when this happens, it no longer has any debt and so would not engage in a debt-to-equity swap. In Chapter 11 bankruptcy, Corporation A would continue operating, and focus on reorganizing and restructuring its debt. A debt-to-equity swap during Chapter 11 involves Corporation A first canceling its existing stock shares. Next, it must issue new equity shares. It then swaps these new shares for the existing debt, held by bondholders and other creditors. Recording the conversion of a $10 million loan to equity allows a corporation to debit its accounting books by the full $10 million, even if the swap was for $1 million or a 10% ownership share, as in the example above. The common equity account is then credited this new equity share—$1 million or 10%. The financial department of a company should also deduct the interest expense to report any losses incurred in the debt-to-equity swap conversion.
