It seems like more and more small investment firms in the micro-cap space are looking to convert third party debt of micro-cap public companies into equity. Most micro-cap CEOs probably get calls every day with offers to “restructure their debt”, “clean up their balance sheet”, “convert their old debt to equity”, “eliminate liabilities”, etc.
Using rule 144 and/or the exemptions available under Section 3(a)(9) or 3(a)(10) of the Securities Act, investors usually create free trading stock quickly by eliminating an issuer’s debt. While there are instances where converting debt to equity can be truly beneficial for an issuer, the majority of micro-cap debt to equity conversions leave issuers worse off than before the restructure.
So when does converting micro-cap debt to equity make sense? In my opinion, debt restructures are most helpful for revenue generating companies who can use cash, that would have been used to pay debt, to fuel growth. For pre-revenue companies, a debt restructure tends to be a much riskier proposition.
Below, I break down the Pros & Cons Of Converting Micro-Cap Debt To Equity.
1. Repurpose Cash Flows – Revenue generating companies can repurpose cash flow to fuel growth. Income that would have been slated to pay liabilities can be used for other purposes. By reducing or eliminating payables for things like inventory, marketing, R&D, and general admin, a company can temporarily increase available cash flows from operations and use those cash flows to fund growth.
2. Maintain Creditor Relationships – Converting liabilities into equity allow issuers to maintain a strong relationship with creditors. Meeting obligations to creditors (including investors, lenders, suppliers, and service providers) allow for continued access to those credit sources.
3. Speed – When creditors need to be satisfied quickly, converting debt to equity tends to be one the fastest options. With no registration statements, no extensive underwriting or due diligence, and “boilerplate” legal documentation, investors in these transactions can fund in as little as a few days with minimal upfront costs to the issuer.
1. Little Value Creation – Debt to equity conversions usually do little in the way of creating traditional value for micro-cap issuers and their shareholders. Maintaining a strong relationship with a key creditor or supplier can be important and beneficial but the costs often outweigh the benefits.
2. Poor Reception – Investors usually view these transactions as a last ditch effort by management. Some of the standard debt to equity terms can be discouraging to market investors and future direct equity investors. With little value creation and less than ideal terms, market support for newly issued (primarily free trading) equity tends to be limited.
3. Temporary Solution – These transactions usually don’t solve long-term cash flow and/or financing problems. Rather, they tend to hamper an issuer’s ability to raise future funding and don’t provide a path to satisfying the same creditors in the future. Additionally, satisfying older liabilities, that may not have required immediate payment, only increases short-term dilution without solving the issuer’s short-term business or financing needs.
In short, converting debt to equity can be a useful tool but it is often used in the wrong situations, by the wrong companies, for the wrong reasons. In my opinion, these types of transaction best serve revenue producing companies and do more harm than good for pre-revenue micro-cap issuers.
Ben Kotch is a managing director and investment committee member at Acquis Capital, LLC, a private investment firm that specializes in acquisitions. He has extensive experience with both private and public companies. Ben graduated with an economics degree from Bentley University where he concentrated in entrepreneurship and law.
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