Understanding the Conversion of Loan to Equity: A Detailed Guide Under the Companies Act

  • Setindiabiz Team
  • June 27, 2023
Understanding the Conversion of Loan to Equity
In this corporate landscape, businesses strive to adopt the latest strategies to sustain for longer and boost their financial structure. Conversion of Loans into Equity is one of such strategies that is highly in focus. A number of benefits are associated with this procedure which go as improved balance sheet, reduction in debts/loans, and higher investor confidence.
But are you aware of the fact that how does this process work? Regulations mentioned in the Companies Act, 2023 for conversion? Getting well-versed with the complexities can help business owners, investors as well as financial professionals making better decisions.
This comprehensive guide on the ‘Conversion of Loan to Equity’, makes you familiar with the complexities that may arise during the conversion process, guided by the provisions outlined under the Companies Act. With this blog, you will get to know about the legal framework, pre-conversion considerations, essential checklist, step-by-step process for conversion of loan to equity, and also post-conversion implications.
Learn different necessary aspects of the loan conversion into equity as it will help you minimize the complexities associated with the process.

Part I: Understanding the Legal Framework

  1. Definition & Explanation of Related Terminologies Before taking a closer look into the legal structure of conversion of loan into equity, it’s better to understand the key terms associated with this procedure; three main terms are described below;
    1. A loan is a kind of fund that is borrowed by a business/company from an individual, institution or any other entity. It is granted with an obligation to repay the loan amount with interest for the specified time.
    2. On the other hand, Equity represents ownership in a company. It is often granted as issuance of shares/stock.
    3. Conversion is a regulatory process of converting a loan into equity. It allows a creditor to become a shareholder of the company.
  2. Brief Introduction to the Companies Act and Section 62(3) The Companies Act, 2013 serves as the primary legislation regulating the functioning as well as  operations of the companies. Section 62(3) of the Companies Act consists of the provisions that  allow conversion of loans into equity. The Section extends authority to a company to approve the special resolution passed by its shareholders which allows conversion of its loans into shares of the company.
  3. Rules made under the Companies Act: The Companies (Share Capital and Debentures) Rules, 2014 (the “Rules”) have a major impact on providing provisions and guidance for the conversion of loans into equity. These rules also consist of certain terms & conditions which must be met for the conversion of loan into equity.

Part II: Pre-Conversion Considerations

A company is required to pass a special resolution while accepting the loan in order to have a successful conversion of loan into equity. The resolution highlights that the loan may be converted into equity in the future. It is necessary to ensure that the lender is well aware of the possibility of conversion of loan to equity, and that they have agreed to this possibility. The special resolution must have the following provisions:
  1. The terms and conditions based on which the loan may be converted into equity, mainly the date & time when the conversion might take place, the number of shares that will be issued in exchange of the loan, and also the price of each share.
  2. The details of the conversion procedure, mainly the required steps that the company and the lender must follow for completion of the conversion procedure. 
  3. A special resolution must be passed by a majority of the company’s shareholders at a general meeting. After passing of that resolution, the company may allow such conversion of loan into equity at any time in the coming time. However, it is subject to the terms and conditions specified in the resolution.

Part III: Checklist for Converting a Loan into Equity

  1. First, check whether the loan agreement contains provision for the conversion of loan into equity. The loan agreement must also have provisions that clearly say that the loan can be converted into equity. It must also include the terms and conditions that allow legitimate conversion.     
  2. Check whether the company has passed a special resolution at the time of obtaining the loan. This resolution outlines that the loan might be converted into equity in the future. Also make sure that the lender is well-versed with the chances of the loan conversion into equity, and also the involved parties have agreed to this possibility. The special resolution must be passed by a majority of the company’s shareholders at a general meeting. When the special resolution has been passed, the company may convert the loan into equity at any time in the future; depends on the terms and conditions specified in the resolution.   
  3. Check if the company has necessary approvals from the shareholders and the lender to convert the loan into equity. Moreover, it also should have passed a special resolution at the general meeting of its shareholders, and the lender must be agreed upon the conditions of conversion.    
  4. Check if the company has necessary documents that are required for the completion of the conversion. It also includes the agreement of loan, the special resolution, and the report of valuation, if required. A valuation report is required for the conversion of a loan into equity depending upon the circumstances.
  5. If the loan was issued with the provision to convert it into equity at a predetermined price, then no valuation report is required. This is because the price of the shares to be issued in exchange for the loan is already disclosed.
  6. However, if the loan was issued without the option to convert into equity, or if the terms of the conversion are not yet finalized or agreed upon,in that case a valuation report may be required. It determines that the shares issued in exchange for the loan are fairly valued.
  7. The Companies (Share Capital and Debentures) Rules, 2014, require a valuation report if the loan conversion into equity results in the issue of shares for a consideration other than cash. It indicates that if the shares are issued for a consideration other than cash, i.e. for the transfer of assets or for the provision of services, a valuation report must be presented. 
  8. The report  of valuation must be prepared by a valuer registered with the Insolvency and Bankruptcy Board of India (IBBI).
  9. The valuation report should also consist of the details of conversion, i.e. the price per share and the number of shares to be issued.

Part IV: Step by Step Process for Conversion of Loan to Equity

Step by Step Process for Conversion of Loan to Equity

Step 1: Check if the loan agreement allows for loan conversion into equity

Check if the loan agreement possesses all the essential terms & conditions for converting a loan into equity. The loan agreement should outline if the loan can be converted into equity and the terms and conditions of the conversion. And if the loan agreement does not permit this conversion, the company cannot convert a loan into equity.

Step 2: Special Resolution At time of Acceptance of Loan

It is also necessary to check if the company has passed a special resolution at the time of accepting the loan, which mentions that the necessary terms & conditions ensure that the loan may be converted into equity in the future. Also check whether the lender is aware of the possibility of the loan being converted into equity, and that they have agreed to this possibility.

Step 3: Obtain a valuation report (if required)

The Companies (Share Capital and Debentures) Rules, 2014, require a valuation report if the conversion of the loan into equity leads to the issue of shares for a consideration other than cash.

Step 4: Pass a board resolution approving the conversion of the loan into equity

The board of the company must pass a resolution consisting of the required provisions to approve the loan conversion to equity. This resolution should include the below information:
  1. The Terms & Conditions at which the loan is being converted into equity. 
  2. The Number of shares that are to be issued in exchange of loan.
  3. The Price per share. 

Step 5: Pass Special Resolution

Call a general meeting of the shareholders and pass a special resolution that can approve loan conversion into equity. The special resolution must be passed by a majority of the shareholders present through voting at the general meeting.

Step 6: File MGT-14

The special resolution passed in the shareholders meeting must also be filed with the Registrar of Companies (ROC) using the prescribed form MGT-14. The form must also be filed to ROC within 30 days of the date of the general meeting in which the conversion of loan into equity was approved.

Step 7: Issue of New Shares

The company must issue new shares to the lender in exchange for the amount of the loan that is being converted into equity. The shares should be issued at the price per share that was specified in the board resolution and the special resolution. PAS-3 Form needs to be filed to the ROC for issue of new shares.

Part V: Post-Conversion Implications

After conversion of loans into equity, there are several implications; financial and operational, both, that a company needs to understand:
  1. Balance Sheet Improvement: When a loan is converted into equity, the liability section of the balance sheet decreases, which in turn decreases the company’s financial risk and improves the debt-to-equity ratio.   
  2. Potential Dilution of Existing Shareholders: The conversion of loans into equity results in the issuance of new shares, which means the shareholding percentage of the existing shareholders gets  diluted. It can affect the distribution of dividends as well as voting rights.
  3. Increased Compliance: Due to foraying of new class of shareholders, there may be an increase in reporting and disclosure obligations to comply with the corporate governance norms.
  4. Tax Implications: Conversion of loans into equity can result in various tax implications. For example, this conversion may cause a taxable event to arise depending on the jurisdiction. Reach out to a financial expert to learn about the process of conversion and other related aspects.    
  5. Changes in Control and Decision Making: If the lender turned shareholder, holds majority of the company shares, it may impact the company’s decision-making process and eventually, the overall direction of the company.      
  6. Enhanced Investor Confidence: A balance sheet reflecting a healthy finance and reduced financial risk condition can boost investor confidence by making a company more appealing to the future investors.

The loan conversion into equity can be beneficial for the betterment of a company’s financial health and also appeal to investors. The conversion process primarily consists of navigating a regulatory framework and understanding the financial and operational implications. As a result, it’s advisable to the companies looking to opt for this strategy, to seek legal and financial guidance from the experts to finalize the process of conversion of loan into equity properly.

Conclusion

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