Debt-to-equity swap

What it means

A debt-to-equity swap converts a creditor's claim against a company into a business share or shares. The company gets rid of a liability and strengthens its equity, while the creditor becomes a shareholder who, instead of repayments and interest, hopes for growth in the company's value.

It is most often done as part of a capital increase. The creditor undertakes to make a contribution, and its claim is set off against the obligation to pay up that contribution. No money physically moves; only the structure of funding on the liabilities side changes.

A swap is used mainly when the company has no means to repay the debt or is over-indebted. It typically involves shareholder loans provided in a difficult period, but also bank loans in a restructuring, when creditors prefer a stake to a loss.

How it works in practice

The law allows a claim to be set off against the contribution obligation in a capital increase if the general meeting approves it. The resolution must state the amount of the claim and how it is set off, and the change is entered in the commercial register like any other capital increase.

A claim can also be contributed as a non-cash contribution, but then an expert must value it. What matters is the claim's real value, not its face amount; if the debtor is over-indebted, the real value of the claim may be much lower.

In a restructuring, a swap is often part of the restructuring plan approved by classes of creditors. In startups a similar result is achieved through a convertible loan, which converts automatically into equity in the next funding round.

What to watch out for

Tax and accounting consequences should be assessed in advance. Extinguishing a liability by set-off against a contribution is not recognised as income, but where part of the debt is forgiven or the face and real values differ, taxable income may arise for the debtor and a loss for the creditor.

Existing shareholders are diluted by the swap and the creditor gains voting rights. A bank or investor often also asks for changes to the statutes, seats on company bodies or preferential rights. It is therefore sensible to agree the terms of entry in a contract before the general meeting.