Debt to Equity Exchange
A debt for equity exchange occurs when a company offers equity, namely stock, to its debt securities holders. There are different reasons why a company would make the offer. Reduction of future debt obligations is a motive. Interest payments alone can be a burden on a company's bottom line. The company and its lenders negotiate a set ratio of debt securities to equity securities based on the prevailing stock prices within a certain time frame.
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Considerations
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Bondholders may decide to accept the offer in hopes of minimizing any losses if the company has problems that could lead to insolvency. By accepting the swap, the bondholders forgo future interest payments and payment of the principal when the bonds mature. The lenders try to get a low equity price to increase the likelihood of a future profit.
Company Advantages
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By reduction of interest payments and elimination of future principal payment obligations, the company can focus capital and effort on growing the business. This will also improve their credit rating. All businesses rely on credit to meet future needs for equipment, supplies and inventory. The improved credit rating means lower interest rates when credit is needed.
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Company Risks
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The debt to equity exchange converts the lenders into shareholders. Depending on the type of equity issued to the lenders, the lenders could receive voting rights at the shareholders meetings. If the lenders get enough voting shares they can request changes in company policy and procedure. This could disrupt the long-term planning set up by management. If the former lenders lack the background and expertise on the company's business plans, future growth could be inhibited.
Lender Advantages
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A debt to equity swap could result in higher profits than the original bond could generate. By helping the company during a period of weak profits the lender's forbearance could reverse the company's performance and make the stocks increase in value for their long-term benefits. The biggest disadvantage a bond has is the guaranteed returns will not go up as the company prospers.
Lender Risks
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The debt to equity swap means the lenders take on the risks of being a shareholder. Shareholders are not guaranteed by contract to any future payments. Shareholders take equity positions based on their research of the company and its ability to increase share value over time. If the company becomes insolvent, the lenders turned shareholders also give up the right to receive any payment from bankruptcy proceedings. Since bondholders have a contract, their losses would be settled before the shareholders.
Other Reasons
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Lenders can initiate a debt to equity exchange if they believe the risks are worth the rewards. If they see steady improvement and innovation, they may want to participate in the long-term prosperity of the company. Companies can initiate a debt to equity swap if they want to reward the lenders with the opportunity to prosper with the shareholders.
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References
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