These are uncertain times for businesses. The economy in the UK, and throughout much of the world, remains largely in lockdown and this continues to have a serious impact on businesses of all sizes. There is also little clarity on what the economy will look like when (if?) we return to a more normal commercial environment.
The key concern for businesses is the availability of cash, both to support existing operations, whilst the economic effects of the Coronavirus restrictions are at their most severe, and also to be in a strong position to return to business as usual and recover some of the lost ground as the restrictions are lifted. There may also be opportunities for some businesses as the economy expands again, and competitors struggle, but they will need available cash to take advantage of these.
Clearly the UK Government’s measures to support businesses, such as the furlough and loan schemes, are a key source of support and businesses should look to these first where appropriate, alongside taking the benefit of existing measures, such as the deferral of business rates.
However, this support will not continue indefinitely, and many of the Government measures simply defer costs that must one day be paid (the furlough scheme being the main exception). As such, there is likely to be a strong need for cash when these Government measures cease and the support that has protected businesses falls away. This is especially true if there is a time lag for business to return to normal (pre-Coronavirus) levels of activity and cash generation.
An important part of this is the need to manage debt carefully, and use it to the best advantage for the company to free up cash and allow for further borrowing. This article looks at the conversion of existing debt to equity, and the issuing of new convertible debt, as alternative financing options for businesses navigating this complex commercial environment.
Debt for equity swaps – the reasons
Popular during the financial crisis of 2008, debt for equity swaps can be a key strategy for businesses. In its simplest form, a creditor’s existing debt (including principal and accrued interest) is converted into shares in the borrower. New shares are issued to the lender in satisfaction of the debt and the loan is no longer owed.
From a company’s perspective, there are several advantages to equity over debt:
- A “swap” of debt for equity can improve a company’s balance sheet by reducing its debts and increasing its shareholder funds.
- Interest will no longer be payable, or accrue, on the debt. By contrast, there is no ongoing cost of equity for the company, unless preference shares are issued.
- The rights of enforcement, and other lender protections usually found in finance agreements, will fall away. This will be helpful as a lender will no longer be able to enforce these rights and potentially push the company into a liquidation process.
- By converting existing debt to equity, the company may free itself up to take on more borrowing, on different (and maybe more beneficial) terms. This will increase the cash available to the company.
Of course, the lender will need to agree to capitalise its debt and become a shareholder instead of a lender, which is a very different proposition. In particular, if a lender has the benefit of security over the borrower’s assets, becoming a shareholder may be seen as a backwards step, because a shareholder will rank behind even unsecured lenders in an insolvency. However, a lender might agree to do so for a number of reasons:
- The lender may have little choice if, for example, the company is in real financial difficulties and there is no real prospect of the debt being repaid. This will be the case particularly if the lender is an unsecured lender or if it stands behind other significant secured creditors.
- The lender may consider that there will be a greater financial upside as a shareholder (with the potential for future dividends and a capital gain on sale) than as a lender (where all it can expect is the repayment of the debt, interest and costs).
- There may also be strategic reasons to capitalise debt. Doing so may give the lender a controlling shareholding in the company, especially in circumstances where the company has a weaker negotiating position and the terms of the debt for equity swap will be particularly beneficial to the lender.
- The lender might be in a position to acquire shares at a lower price than usual, and it may therefore see this as a good investment, particularly now while the future is not clear and company valuations are likely to be depressed.
The other interested parties are the other shareholders, who will be concerned about dilution of their shareholdings and the market value of their shares. Whether or not the shareholders consent to the deal will likely depend on a number of factors, including:
- The amount by which their shareholdings are to be diluted.
- The identity of the new “shareholder” and the control they will have over the company on conversion of their debt.
- The trading prospects of the company if the deal is not accepted.
- How the deal is communicated by the Board.
The key commercial points to be considered are:
- how much debt is to be converted for equity?
- how many shares in the company should be issued to satisfy the conversion (ie what is the market price for the shares)?
- what class of shares are issued and what rights will attach to the newly issued shares?
These points will need to be agreed as part of the commercial negotiation of the debt for equity swap, and they are considered in more detail below.
Issuing new convertible debt
A company seeking access to new funds could, as an alternative to issuing new shares or arranging a more traditional loan, consider issuing convertible debt to an investor.
For private companies, this is most commonly achieved by the issue of convertible loan notes, to a single investor or to multiple investors. The loan notes can be converted into shares in the company at some point in the future, on the occurrence of certain trigger events, such as if the loan is not repaid by a certain date, the completion of a financing round, the change of control of the company or an “event of default” or material breach of the terms of the loan note.
Many of the same commercial points that will need to be agreed between the parties on a conversion of existing debt will also need to be considered when a company issues convertible debt to a third party, but in addition the following will also need to be agreed in advance of the issue:
- When can the conversion take place? Can either the company or the investor force the conversion, or will only the investor have that right?
- Will the investor protect their loan by taking security over all, or some of, the company’s assets?
- What price per share will apply to the conversion (or what formula will be used to determine the price)?
The key terms of the deal
The market value of the company for the purposes of the conversion of the debt will need to be agreed, or for a convertible loan, a formula for determining that price at the time of the conversion will need to be included in the documents. Will this be at market value, or a discount to market value (as an incentive to the lender to agree to these arrangements) or another agreed formula?
The valuation question is important to the investor as it will want to receive as many shares as possible for the value of the debt, and will be arguing for a low valuation or a discount to the market price. Whether or not this is acceptable to the company will depend on the circumstances and the negotiating position of the parties. Directors will also need to make sure that they comply with their directors’ duties and other obligations in making a decision to convert debt to equity and the terms on which it is done.
As the existing shareholders will need to vote in favour of the issue of any new shares, and as this will result in their own shareholdings being diluted, the valuation question is a key one for them too; it is not just a Board decision and the shareholders will need to be engaged and included in the process. Shareholders may be more inclined to accept a further share issue or a discount to market value where the company is in serious financial difficulties.
Where the price is likely to be at a discount, or at a lower price to the prior investment round (a “down round”) the question of valuation becomes even more key.
Class of shares
Often ordinary shares will be issued, and the lender will become a shareholder on the same terms as the existing shareholders. However, it is possible to convert the debt into any class of share, for example:
- A separate share class, which have economic rights but may not have voting rights. This gives the lender an economic exposure to the company (the upside for it) but not the ability to influence the company as a shareholder (protecting the existing voting structure of the company).
- Redeemable preference shares, which are close in character to unsecured debt, but have a priority right to the coupon (as a substitute for the payment of interest on the debt being capitalised) and repayment of capital. The ability of the company to make these payments will be affected by company law, which places restrictions on the payment of dividends and redemption of shares. There may also be the option to convert the preference shares into ordinary shares, for example at the time of a sale of the company to a third party.
A lender may also look for veto rights over certain key decisions affecting the company (if not full voting rights), together with the right to appoint a director or an observer to the board of the company.
A company should also expect be required to provide regular and detailed financial and operational information. This may not be too different to the information rights in a finance agreement.
Timing of the conversion
On a debt for equity swap, the conversion of the debt is the immediate concern and the timing will not need to be negotiated (though acting quickly may well be a necessity if the company is in financial difficulty and unable to pay its debts).
An existing creditor is unlikely to need to carry out significant due diligence on the company, as it will most likely have been provided with regular financial and operational information from the company under the terms of the original finance documents entered into on provision of the loan that is to be converted.
The following documents, setting out the terms of the equity to be issued, will however need to be agreed before the conversion takes place:
- revised articles of association of the company, setting out the rights attaching to the new shares to be issued (unless the creditor is to receive shares of an existing class with no additional rights attached); and
- potentially, a new shareholders’ agreement between the company, its existing shareholders, and the creditor(s) whose debt is being converted, setting out any additional rights for the creditor (such as provision of information, veto rights, and director appointment rights).
An investor subscribing for convertible debt may require the issuing company to grant security (although this is not usual if the convertible debt is provided as a “bridge” facility until further equity financing is attained by the company in the near future). The type of security granted will vary depending on the circumstances of the transaction, but security could be granted over all of the assets of the company, or only over certain key assets.
Debt for equity swaps can give tax advantages for both borrowers and lenders.
The tax position of both the borrower and the lender needs to be considered carefully to ensure a debt for equity swap works to the parties’ best advantage.
The main tax goal for most borrowers will be to avoid a tax liability on the debt for equity swap itself. Fortunately, it is usually possible to achieve this, depending on the accounting treatment of the loan before the swap and the terms of the swap itself. To ensure that borrowers get maximum value from a debt for equity swap, close attention should be given to any potential change in control of the borrower that could be triggered as a result of the swap.
This is crucial because a change in control of the borrower could trigger various adverse tax consequences, including retrospective withdrawal of tax relief and de-grouping tax charges, which could significantly reduce the benefit of the swap in the first place. Tax anti-avoidance rules can also trigger unexpected tax liabilities for borrowers on certain swaps, so the position needs to be carefully checked in each case.
Generally, lenders can be eligible for tax relief on a debt for equity swap, provided the debt is not convertible and the parties are not connected (for example, they are not members of the same group). Specific rules determine the amount of relief the lender may claim, but relief is usually capped at the value of the loan immediately before the swap. In addition, no stamp duty should be payable on a straightforward debt for equity swap.
The shares acquired by the lender under the swap are typically treated as though they had been purchased for a price equal to the market value of the debt immediately before the swap for capital gains tax purposes. This means that any later sale of the shares by the lender should only attract tax if they have increased in value following the swap, and lenders may be entitled to tax relief if the shares reduce in value. However, this does depend on the precise terms of the arrangements, which therefore need to be carefully checked to determine the position.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, May 2020