The debt to equity conversion agreement is a contract signed between the borrower of debt and the lender stating that the borrower converts the amount payable into equity shares. In other words, when the borrower decides to do the payback by converting the amount of the debt into equity shares of his company, both parties agree to sign an agreement.
It is also known as convertible debt agreement or conversion of loan into equity agreement. No cash transaction takes place in this agreement and all the adjustments of the debt are made through the transfer of equity which is stated in the agreement. The debt to equity conversion is finalized when the lender agrees to the same and all the terms and conditions are thereof decided.
When Do You Need a Debt to Equity Conversion Agreement?
In debt to equity conversion agreement, the debt borrowed by the borrower is exchanged for equity stock or shares by signing of a contract by both the parties. The purpose of the debt to equity conversion agreement might include the following situations:
- To help a struggling company so that it can continue its operation.
- When subsequent funds are raised by the company exceeding a certain amount. This situation is also known as qualified financing.
- In case of change of control also known as a liquidity event.
- One other reason can be obligation related to a contract which includes maintaining a target ratio of debt/equity.
Key Terms of Debt to Equity Conversion Agreement Include:
- General information of both the lender and the borrower.
- Amount of debt to be paid
- Total debt in records
- The conversion ratio of debt to equity
- The date on which the conversion is done
Inclusions in Debt to Equity Conversion Agreement
The two parties who sign the agreement for effective conversion include:
- The borrower: who has borrowed money and wishes to convert the debt into an equity
- The lender: who owns borrower the money and agrees on the conversion of debt to equity
The agreement includes all the details and signatures of both parties involved. The effective date is the date on which the conversion is done by agreeing on various terms and conditions.
How to Draft a Debt to Equity Conversion Agreement
Drafting a debt to equity conversion agreement includes the following steps:
- Proposal of conversion: First the borrower approaches the lender with the proposal of conversion of debt to equity.
- Approval of conversion: The approval is gained by the lender for the effective implication of the conversion.
- Creation of the agreement: Both the parties decide on terms and condition of the agreement. The agreement also includes converting debt to equity tax implications which explains in detail the rules both parties have to deal with regarding tax payment.
- Valuation cap: Stating the conversion ratio of debt to equity.
- The signing of the agreement by both the parties: Both the parties then sign the agreement using authorized signatories in the agreement of the terms and conditions stated in the contract.
Also, note that some debt agreements include the debt to equity conversion clause already depending on various conditions stated.
Benefits of Debt to Equity Conversion Agreement
Having a verbal agreement over financial deals especially involving money is a bad idea on so many levels. The debt to equity conversion agreement has the following benefits:
- It contains all the terms and conditions, be it general or related to tax implication, so that no further confusion or conflict takes place.
- The agreement also includes the details of the conversion rates. This helps the lender in case the rates of shares rise in the future when the company recovers.
- The agreement terms and conversion rate is also helpful for the borrower in case of further crises faced by the company.
Conversion of loan into equity by a private company also needs to have an agreement to avoid future consequences. The consequences of not having an agreement might result in conflicts between the two parties if the company recovers.
Key Terms/Clauses in Debt to Equity Conversion Agreement
Apart from the basic information like the general information of the parties involved and the amount of debt some other details are also included in the agreement. The debt to equity conversion agreement includes:
- Total debt outstanding on records as well as the total debt payable.
- The conversion ratio of debt to equity.
- Date of conversion of the debt to equity.
- It also contains the terms and conditions on which both the parties agree.
- It also contains the tax implications to be followed by both parties.
Sample for Debt to Equity Conversion Agreement
A sample of the agreement can be downloaded from below.
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