A company may engage in debt for equity swaps with shareholders for a variety of reasons. The debt for equity swap allows a company to call back a portion of its stock by paying stockholders. Often, the company will even offer increased financial incentive by paying the stockholders more than the stock is worth on the market. The company has its own reasons for completing a debt for equity swap, such as lender requirements, financial performance and managerial desires.

Debt for Equity Explanation

Most companies issue equity in exchange for debt multiple times throughout their businesses' life cycles. They give investors or employees a certain amount of stock. In exchange, investors give them money, or employees take lower paychecks. The result for the company is a little extra money at a time when it is needed for expansion or to otherwise stay in good financial health. There are times, though, when a company must actually reclaim its equity to remain in good financial health. At that point, a company will ask to recall equity, taking back parts of its ownership and paying off those who currently hold the shares.

Debt for Equity Example

Company XYZ is seeking a business expansion loan to build a new factory. XYZ would like to receive a loan in the amount of $1,000,000. A lender reviews XYZ's earnings, assets and liabilities. The lender determines that in order to permit this sizable loan, it will need to see XYZ increase existing assets by $50,000 while reducing liabilities by the same amount. To accomplish this, Company XYZ plans to repurchase $50,000 worth of stock from shareholders. It will increase its equity by $50,000, and it will owe investors less money through dividends each year.

The problem is, however, that the investors do not want to sell. In order to entice investors, XYZ offers up to 1.5 times the actual cash value of the stock at hand. Now, investors would prefer to resell the shares to XYZ rather than hold on to the shares or sell elsewhere. The move has cost XYZ $75,000. Of that, $25,000 is straight expense; the other $50,000, though, is converted back into equity for the company in the form of shares it now owns. XYZ gets its $1M loan as well, increasing its financial strength in order to expand. 

Reasons to Exchange Debt for Equity

The above example is just one reason a company would want to repurchase shares and exchange debt for equity. Another potential scenario may arise when the company would like to engage in a merger and needs to improve its financial position in order to entice buyers. At times, the management of a company will feel it has sold too much equity and is at risk of a takeover. In this case, the board of directors will be rebuying equity in order to assure that they retain control of the company in the future. In all of these scenarios, the goal is essentially to take a "step back" in the number of shares the company is currently listing on the market. 

blog comments powered by Disqus