When a company needs more cash than is currently being generated by its operations, it has essentially two ways to get it. It can borrow the money it needs, known as debt financing. Or it can sell a share of ownership, referred to as equity financing. One advantage of equity financing is that, unlike borrowed money, the cash raised doesn't have to be paid back. That's a major reason why companies convert debt to equity.
A debt-equity swap is a simple and long-used method of converting debt to equity. In a swap, a company agrees with a lender to eliminate some or all of its debt in exchange for an ownership stake in a company. Say a public corporation with a current stock price of $20 owes a bank $1 million. If the company lacks the cash to make its debt payments -- or if it would just prefer to use the cash for other things -- it could offer the bank 50,000 shares of its stock. The bank gives up its right to collect the $1 million, but it is now a part owner of the company with a stake worth $1 million.
Companies can also plan debt-to-equity conversions ahead of time by issuing convertible bonds. Investors who buy bonds are lending money to the issuer. They get their money back when the bond matures; in the meantime, they earn interest. Investors who own convertible bonds, however, also have the option of redeeming those bonds for a certain number of shares of company stock -- say, two shares for every $100 worth of bonds. If the convertible bond is "callable," the issuing company can force bondholders to convert their bonds into shares.
Pros and Cons of Swaps
Converting debt to equity gets a company out from under the obligation not only to repay the money it borrowed but also to pay interest. This bolsters its cash flow. However, it does have to give up a chunk of itself in the process. In a debt-equity swap, it may have to surrender a significant amount of control, depending on how much it owes and what the lender demands in return. On the other side of the deal, the lender is giving up its right to be repaid in exchange for a stake in the company that could increase in value -- or could drop to zero. But a company with cash-flow problems could be in danger of insolvency, and if it goes bankrupt, the lender might collect only a fraction of what it's owed or nothing at all. If the firm has valuable underlying assets, converting debt to an equity stake can benefit the lender as well.
Considerations With Bonds
Convertible bonds generally pay a lower interest rate than nonconvertible bonds, as investors who buy them are also "buying" the possibility that they'll wind up with stock more valuable than the bonds. If the stock price rises beyond the break-even point, investors will redeem the shares. Say a $100 bond is convertible to two shares. If the share price is $52, an investor could redeem the bond and essentially get a "discount" of $2 per share. Then again, the company may call in the bonds as the price goes up, forcing redemption before the share price rises too high. And it's always possible that the stock price will stay below the break-even point, so investors never redeem the bonds and are stuck with the low return.