A debt-equity swap (DES) is a debt restructuring in which a creditor provides new equity capital in the debtor in exchange for cancellation of outstanding debt it is owed, thus improving the debtor’s capital base and reducing the debt service. A DES is commonly undertaken to remove excess debt from a debtor’s balance sheet in exchange for the creditor’s control over the debtor and opportunity to participate in future profits if the company becomes profitable.
Conversion can be achieved either through:
- Debtor issuance of new shares to the creditor in exchange for the debtor’s obligations to the creditor; or
- Contribution in cash to the debtor by the creditor used to repay the debt in exchange for the debtor’s issuance of new shares to the creditor.
The positive effects of debt-equity swaps are that they decrease or settle the company’s over-indebtedness, improve the balance sheet structure (i.e., the debt to equity relationship) and, therefore, improve the company’s credit standing.
Debt-equity swaps most often occur when large, overleveraged companies with significant assets run into serious financial trouble and are taken over by their principal creditors. When both the debt and the remaining assets in the companies are large, there is usually no advantage for the creditors to force the company into liquidation. Instead, the creditors prefer taking control of the business as a going concern.
| Accounting by Borrower for a Debt-Equity Swap (Example) | ||||
| RealCo and YourBank do a debt-equity swap on 1 Mar 2017 whereby 32,000 shares of €10 par common stock with a fair value of €1.6m are exchanged in full settlement of a €2m loan. The real estate has a value of €2.1m on RealCo’s books. | ||||
| 1 Mar 17 | Note Payable to YourBank | 2,000,000 | ||
| Capital Stock | 320,000 | |||
| Paid-In Surplus | 1,280,000 | |||
| Gain on Restructuring | 400,000 | |||
| To record debt-equity swap by RealCo with YourBank | ||||