As a business enters an active growth phase, it may encounter a structural issue that is easy to overlook at first. A successful company with strong financial performance approaches a strategic investor or a banking syndicate, only for due diligence to uncover a less obvious risk. A significant part of the company’s operations has been financed over the years through loans provided by its majority shareholder.
For privately held businesses, this is a common way of providing the company with liquidity when funding is needed quickly. For an external investor, however, such intra-group debt may become a serious concern. An investor may be unwilling to take the risk that the company’s future free cash flow will be used to repay historical debt to the founder rather than being reinvested in the business or distributed to shareholders.
Consider a typical transaction scenario. An operating company is preparing to raise capital from an investment fund. The parties have agreed on the commercial valuation of the business, but the company’s balance sheet remains burdened by historical shareholder loans used by the founder to finance its operations. The investor makes it a firm condition precedent to closing that the company’s balance sheet be fully cleared of intra-group debt.
The discussion then naturally turns to more sophisticated legal structuring. One of the established mechanisms for resolving this conflict is a debt-to-equity swap, whereby the company’s debt to the shareholder is converted into equity. The commercial rationale is straightforward. The shareholder’s outstanding claim against the company is discharged, while the shareholder receives an additional equity interest in the business in return. The investor gets a cleaner balance sheet, while the company is relieved of its historical debt burden.
The difficulty begins at the implementation stage. Depending on the corporate structure and applicable law, a seemingly straightforward debt conversion may raise a number of significant legal issues.
For a company incorporated as a limited liability partnership in Kazakhstan, a direct debt-to-equity conversion is subject to a specific statutory restriction. The Civil Code of Kazakhstan (Article 59.1) prohibits contributions to the charter capital of a partnership by way of set-off of a participant’s claim against the partnership, except where otherwise provided by the laws of the Republic of Kazakhstan. This prevents the parties from simply treating the shareholder’s existing claim as a contribution to the company’s charter capital through a straightforward set-off.
Attempting to work around this restriction without carefully considering the legal structure may create a risk for the transaction as a whole. Depending on the structure used, the parties may face challenges to the validity of the relevant transactions, including allegations that the arrangement was designed to circumvent mandatory statutory requirements. Poorly structured transactions may also give rise to unexpected tax consequences, which can directly affect the financial assumptions underlying the investment.
A different legal environment applies when the transaction is structured within the Astana International Financial Centre (AIFC). The AIFC law is based on the principles of English common law, under which debt-to-equity conversions are a familiar and widely used mechanism in corporate and investment transactions. The AIFC legal framework provides the flexibility needed to structure such transactions in a manner that is workable and familiar to international investors.
That flexibility, however, should not be mistaken for a universal solution. In practice, the same commercial objective may be achieved through several materially different structures under AIFC law. English law offers a broad range of transactional tools, each with its own mechanics, requirements and potential consequences. Choosing the wrong structure may create unexpected corporate or tax risks even within a flexible legal environment.
A debt-to-equity swap is therefore more than a technical mechanism for removing debt from a balance sheet. Its successful implementation requires a clear understanding of both mandatory local requirements and the structuring principles applicable to international transactions. The real question is not simply how to convert an existing claim into equity, but how to design a legal structure that can withstand investor due diligence and support the transaction over the long term.
At this stage, careful legal structuring is not merely an ancillary part of the transaction. It can be a decisive factor in getting the deal across the finish line while protecting the company’s and shareholders’ interests beyond closing.
Planning an investment transaction with shareholder debt on the balance sheet?
A debt-to-equity swap can help resolve intra-group debt issues, but only if the transaction is structured in compliance with applicable law and does not create new corporate or tax risks.
REVERA’s lawyers advise businesses on structuring debt-to-equity conversions in Kazakhstan and under AIFC law, taking into account the corporate structure, investor requirements, tax implications and closing conditions.
If an investor has already required the balance sheet to be cleared of shareholder debt, or you are considering a debt-to-equity conversion, speak to our lawyers before implementing the structure.
