Debt-to-equity swaps are common transactions in the financial world. They enable a borrower to transform loans into shares of stock or equity. Most commonly, a financial institution such as an insurer or a bank will hold the new shares after the original debt is transformed into equity shares.
Understanding and Calculating Equity
Equity is money that's invested in a corporation or enterprise by owners who are called shareholders. The shareholder usually receives voting rights and can vote in yearly meetings that concern the corporation or the enterprise’s management or next steps.
The shareholder receives cash flow from the equity they own if the entity pays dividends. The shareholder might realize a profit, a loss, or no change in the original capital invested at all when they sell the equity.
The equity of an entity or corporation is calculated by subtracting its combined assets from its total liabilities. The net worth of the corporation or enterprise represents its equity, or what the entity owns less what the entity owes.
A Debt-to-Equity Swap
The lender converts a loan amount or a loan amount represented by outstanding bonds into equity shares when it's converting debt to equity. No actual cash is exchanged in the debt-to-equity swap.
A General Example
Here's how it works: Corporation A might owe Lender X $10 million. Instead of continuing to make payments on this debt, Corporation A might agree to give Lender X $1 million or a 10% ownership share in the company in exchange for erasing the debt.
When and Why Does This Occur?
This type of transaction most commonly occurs when a company is undergoing some financial difficulties so it isn't easily able to make the payments on its debt obligation. The financial difficulties are anticipated to be long term so an immediate fix is necessary to restore financial equilibrium. A company might also want to improve its cash flow by converting debt to equity.
In some cases, lenders might suggest or request a debt-to-equity swap, while the corporation might ask for one in other situations.
A Useful Tool in Bankruptcy
Debt-to-equity swaps can also happen in markedly bad situations such as when a company must file for bankruptcy. They can occur as a result of bankruptcy proceedings. In most cases, the process is the same.
If Corporation A can't make the payments on the debt owed to Lender X, the lender might receive equity in Corporation A in exchange for the debt being discharged or eliminated. The exchange would be subject to the approval of the bankruptcy court, however.
If a company files Chapter 7 bankruptcy, it liquidates all of its assets to repay creditors and shareholders. Since the business ceases to exist, it no longer has any debt and so would not engage in a swap transaction. In Chapter 11 bankruptcy, the company continues operating and focuses on reorganizing and restructuring its debt.
A debt-to-equity swap during Chapter 11 involves the company first canceling its existing stock shares. Next, the company issues new equity shares. It then swaps these new shares for the existing debt, held by bondholders and other creditors.
Accounting for the Debt-to-Equity Swap
The corporation’s financial department makes journal entries on the date of the transaction to account for the debt-to-equity swap. Converting the entire $10 million loan to equity on the date of the transaction allows the corporation to debit the books by the full $10 million.
The common equity account is then credited by the new equity issue—in this example, at $1 million or 10%. The financial department also deducts the interest expense to report any losses incurred in the debt-to-equity swap conversion.