What Is a Debt-to-Equity Swap?

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Definition

Debt-to-equity swaps are transactions that 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.

Key Takeaways

  • Debt-to-equity swaps are most commonly seen in the financial industry and with developing countries.
  • This move makes it possible for borrowers to turn loans into shares of stock or equity.
  • Usually, a financial institution holds the new shares after the debt is “swapped” into equity shares.

How a Debt-to-Equity Swap Works

With a debt-to-equity swap, the lender converts a loan amount or a loan amount represented by outstanding bonds into equity shares, thus converting debt to equity. No actual cash is exchanged in the debt-to-equity swap.

Equity is money that is invested in a company by owners who are called shareholders. A shareholder usually receives voting rights and can vote in annual meetings that concern the company’s management or next steps.

A shareholder receives cash flow from the equity they own if the company pays dividends. The shareholder might earn a profit, suffer a loss, or earn nothing on the original capital they invested if/when they sell their equity.

Note

The equity in the company is calculated by subtracting its combined assets from its total liabilities. The net worth of the company represents its equity, or what it owns minus what it owes.

A debt-to-equity swap most commonly happens when a company is going through some financial difficulties. That usually makes it hard to make payments on its debt obligations. An immediate fix to these hard times is necessary to restore some financial stability, so a company might want to improve its cash flow by converting debt to equity.

Note

Debt-to-equity swaps can also happen when a company files for bankruptcy, as a result of bankruptcy proceedings. In most cases, the process is the same.

Examples of Debt-to-Equity Swaps

Let’s look at an example of what a debt-to-equity swap is and how it works. Let’s say Corporation A owes Lender Q $10 million. Instead of continuing to make payments on this debt, Corporation A might agree to give Lender Q $1 million or a 10% ownership share in the company in exchange for erasing the debt.

In the case of bankruptcy, if Corporation A can't make the payments on the debt owed to Lender Q, the lender could receive equity in Corporation A in exchange for the debt being discharged or eliminated. However, the exchange would be subject to the approval of the bankruptcy court.

If Corporation A files Chapter 7 bankruptcy, it liquidates all of its assets to repay creditors and shareholders. Since the business ceases to exist when this happens, it no longer has any debt and so would not engage in a debt-to-equity swap.

In Chapter 11 bankruptcy, Corporation A would continue operating, and focus on reorganizing and restructuring its debt. A debt-to-equity swap during Chapter 11 involves Corporation A first canceling its existing stock shares. Next, it must issue new equity shares. It then swaps these new shares for the existing debt, held by bondholders and other creditors.

Note

A corporation’s financial department makes journal entries on the date of the transaction to account for the debt-to-equity swap.

Recording the conversion of a $10 million loan to equity allows a corporation to debit its accounting books by the full $10 million, even if the swap was for $1 million or a 10% ownership share, as in the example above. The common equity account is then credited this new equity share—$1 million or 10%. The financial department of a company should also deduct the interest expense to report any losses incurred in the debt-to-equity swap conversion.

Note

A debt-to-equity swap may also be known as a debt conversion or debt swap.

Frequently Asked Questions (FAQs)

What is the formula for a debt-to-equity swap?

The equity of a company is calculated by subtracting its combined assets from its total liabilities. A company’s debt is simply that—the debt it owes to lenders and whatnot. The formula is simply the agreement to swap a certain amount of debt for a certain amount of equity. It could be $10 million in debt swapped for $1 million or 10% in equity.

How long does it take for a company to swap debt to equity?

How long it takes a company to complete a debt-to-equity swap depends on the unique financial situation it’s in. For example, if the company is in bankruptcy and requires approval from a bankruptcy court, the timeline would depend on the court’s timeline.

Updated by
Jacqueline DeMarco
Jacqueline DeMarco
Jacqueline DeMarco has 7+ years of experience researching and writing dozens of articles. She covers investing, taxes, credit cards and scores, loans, banking, budgeting, and more for The Balance. Jacqueline has been published on LendingTree, Credit Karma, Fundera, Chime, MagnifyMoney, Student Loan Hero, ValuePenguin, SoFi, Northwestern Mutual, and more.
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. IRS. “Equity (Stock) - Based Compensation Audit Techniques Guide (August 2015).”

  2. FINRA. “How Companies Use Their Cash: Dividends.”

  3. U.S. Department of Agriculture. “Managing Your Cooperative’s Equity.”

  4. Jaka Cepec & Peter Grajzl. (2020). “Debt-to-Equity Conversion in Bankruptcy Reorganization and Post-Bankruptcy Firm Survival.” International Review of Law and Economics, 61.

  5. IRS. “Chapter 7 Bankruptcy–Liquidation Under the Bankruptcy Code.”

  6. United States Bankruptcy Court, Northern District of California. “What Is the Difference Between Bankruptcy Cases Filed Under Chapters 7, 11, 12, and 13?

  7. U.S. Agency for International Development. “Basic Guide To Using Debt Conversions.”

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