Why Increase share capital by converting loans into shares
When a company is in the start-up stage, cash flow problems may exist and liquidity is needed for the company to operate. Although there are sources of financing available companies often choose to capitalise a loan from shareholders or associates, or even third parties.
What is the conversion of loans into share capital?
The conversion of a loan into share capital occurs when the debtor company cannot pay back the amounts received as loans and the lender agrees that instead of trying to recover the debt he can use this debt to acquire shares in the company. As a result of this operation, the creditor will increase his number of shares in the Company or will become a new shareholder in the company.
According to the provisions of art. 210 para. (2) of the Companies Law no. 31/1990, for joint-stock companies: „the new shares shall be paid by incorporating the reserves, except legal reserves, as well as the benefits and the share premiums or by compensation of certain and liquid debts which are due and payable from the company for its own shares.”. At the same time, according to art. 221 these provisions are also applicable to limited liability companies.
In this way, an increase of the share capital is made without a new cash contribution. The operation is carried out by transferring from an accounting perspective a sum of money between the company’s accounts, respectively from the „debt” account to the „share capital” account.
As well as the increase in the share capital, another consequence of the compensation by receivables often referred to as the conversion of the company’s debts into shares is the settlement of the debt and the release of the company from payment obligation.
At the same time, if the company decides to increase its share capital and issues shares that are subscribed for by a creditor then he may settle the obligation to pay for the shares by offsetting the debts due from the company.
Conditions for converting the receivables into share capital
For converting debt into shares it is necessary first that the claim exists and it is certain, liquid, and due. The existence of the debt is normally proved by a loan agreement concluded between the company and the shareholder / third party creditor, account statements or receipts showing the transfer of money and accounting records relating to the claim showing the payment from the creditor to the company.
In the case of a foreign loan, for example, a loan from a shareholder who is domiciled abroad, if the period of the loan is medium or long, then the company has the obligation to notify the National Bank of Romania regarding this operation as it will be considered as external private debt.
In certain circumstances, the claim can occur from another legal relationship but it is essential that it is liquid and due and payable.
Secondly, there must be a decision of the company to increase the share capital and the intention of the company’s creditor to subscribe for the new shares.
Finally, the legal provisions governing the operation of companies must be taken into consideration. For example, if the debtor becomes a new shareholder through this operation, he must meet the conditions provided by law for holding shares in the company.
Reconciling the interests of the shareholders
One of the aspects that the shareholders of the company must consider is the dilution of their contribution to the share capital. By offering new shares to the company’s creditor, their share in the profits and losses of the company, their voting rights will decrease proportionally to the number of new shares issued.
In the event that the statutes of the company provide for preference in the issue of new shares, this must be complied with. The shareholders can of course waive the right to exercise the right of preference.
Formalities with the Trade Registry
In addition to the decision of the general meeting of shareholders increasing the capital and the updated articles of incorporation of the company, the financial statements and the balance sheet must be also submitted with the application to register the increase of the share capital by converting the debts into shares. Thus, the control performed by the Trade Registry will look at the intention of the shareholders to increase the share capital and the existence of the claim in order for there to be a real increase in share capital.
Further, in practice, although not expressly provided for in the rules of the Trade Registry, additional documents are often required such as evidence of the debt or an accounting report certifying the existence of the debt.
The operation of converting the debts into shares may prove to be a convenient procedure for companies to reduce their indebtedness and to avoid the recording of negative equity. Of course the holding of shares in the company must be on the interest of the creditor so that it is prepared to renounce the whole or part of its debt. Transactions of the nature as outlined above most often take place in the case of loans received from the shareholders or from third parties, when future profits of the company are foreseen as compensation for the unpaid loans.