In our last publication, we introduced business reengineering as a process in which an organization is looked at finely from top to bottom in order to streamline it by ridding it of its inefficiencies and issues. Today we would like to continue that conversation by talking about one of the aspects of reengineering; capital restructuring.
Restructuring is an action taken by a company to significantly modify the financial and operational aspects of the company. This usually happens when the business is facing financial duress or industry pressures so the purpose is to limit financial harm and improve the business. However, though restructurings are induced by negative stimuli, there are other reasons that can induce a restructuring. These include preparing for a sale, buyout, merger, change in overall direction, growth, or transfer of ownership.
Fundamentally, businesses need money to run and function well. This money may come from the revenue and capital injections through debt and the issuance of equity in the business. The latter two are what make up the capital structure of a business. So then, the capital structure of a business is the mixture of debt and equity that the company is working with. There are several factors that might cause a company to alter or tamper with this mixture which happens in a process called capital restructuring.
A Capital restructuring, thus, is a corporate operation that involves changing the mixture of debt and equity in a company’s capital structure. It is done in order to optimize profitability, undertake a growth operation or in response to a crisis like bankruptcy or changing market conditions. It is an approach primarily used to deal with changes that impact a business’s financial stability.
WHAT COULD IMPACT THE CHOICE OF STRUCTURE?
- A company’s risk appetite: Businesses have their own risk profile driven by a range of factors including industry, maturity, scale, management, expertise, client spread, product mix and diversity. The amount of risk a company can manage will determine the portion of debt and equity it will have since cost of capital and reduced ownership will be considered.
- Short-term and long-term goals: Debt or equity is crutial in funding the company’s goals and ambitions and the time horizons for each play a huge part in that decision since both types of funding have their advantages and drawbacks tied into the timelines in which they will be used. For example, equity is not a good way of funding short-term goals since it involved relinquishing ownership and control.
- Financial state: Revenue, cash flow, cash reserves and debt are important in determining whether to use debt of equity since they are what will be used to service the obligations.
- The owners profile: addressing such issues as age, marital status, estate and succession planning, legal issues, intent to sell or intent to pass on to the next generation are important. This is because they have a direct bearing on the future of the company both in the short-term and the long-term. Funding is different for an ordinary business versus a family business. A married operator is not the same as a single operator in terms of the risks they are willing to take. An older business person is likely to be thinking of succession planning and a new founder may have a different vision for the business. It would therefore be unwise for that person to give up equity or take very long-term debts.
- Tax planning: Whatever funding you are using has tax implications that must be considered. Additionally, our tax regulations prescribe capitalization rules that companies must follow. In choosing debt or equity, be wary of the taxes that follow either decision.
TYPES OF CAPITAL RESTRUCTURING
Capital restructuring comes in 2 forms: debt and equity restructuring.
- Debt restructuring
Debt restructuring is the process of reorganizing the whole debt capital of the company. It is typically used to avoid the risk of default on existing debts while providing a less expensive alternative to bankruptcy. Moreover, a company always seeks to minimize the cost of capital and improve its efficiency of the company. This calls for a continuous review of the debt.
Debt restructuring can be done in ways:
- Making use of the market opportunities by substituting the current high-cost debt with low-cost borrowings.
- To reduce the cost of borrowing and to increase the working capital position.
- A debt-for-equity swap, in which creditors agree to cancel a portion or all of the outstanding debt in exchange for equity in the business.
- Formal agreements involving Interest rate renegotiation or extension of the term.
- A ‘haircut’, where a portion of the outstanding interest payments will be written off, or a portion of the balance will not be repaid.
- Then issuance of callable bonds to protect itself from a situation in which it can't make its interest payments since it can be redeemed early by the issuer in times of decreasing interest rates and allows the issuer to restructure debt in the future by replacing the existing debt with new debt at a lower interest rate.
Equity restructuring is the process of reorganizing the equity capital. It includes reshuffling of the shareholder’s capital and the reserves in the balance sheet. Since equity restructuring involves people’s ownership of companies, it is a legal process and is highly regulated. Equity restructuring usually deals with capital reduction.
The following are some of the various methods of an equity restructuring.
- Repurchasing the shares: This helps in reducing the liability of the company to its shareholders resulting in a capital reduction by returning the share capital.
- Change of share nature: This allows the change of equity capital into to redeemable preference shares or loans.
- Writing down the share capital: This reduces the amount owed by the company to its shareholders without actually returning equity capital in cash.
- Consolidation of the share capital or subdivision of the shares.
Reasons behind equity restructuring
- Correction of overcapitalization
- Reorganizing the capital for achieving better efficiency
- To write off unrecognized expenditure
- To maintain a good debt-equity ratio
- For revaluation of the assets
- For raising fresh finance
Capital restructuring is a process your business will have to undergo several times in its lifecycle since your capital structure requires review at regular intervals as well as to keep your business healthy and thriving. So it is important to keep all of these in mind as you run your business and as you think of growth. Additionally, anticipating market dips and recessions will ensure you are on your toes in terms of ensuring that the funding structure on your balance sheet is suitable for the economic conditions in which you operate.