Company restructuring without fixed interest payments and dilution of voting rights

The coronavirus pandemic and its economic consequences are causing economic hardship for countless companies. Participation certificates with preferential rights balance the interests of existing company owners and new investors, as the company compensates investors appropriately for the risks taken, but can determine the timing flexibly based on the economic situation. 

Key Facts:

• Corana pandemic leads to massive financing problems for CH companies
• Federal Council measures is at best a short-term, but not sustainable solution
• Debt financing commits to fixed scheduled interest payments regardless of the liquidity situation and risk of over-indebtedness
• Equity financing leads to dilution of voting rights
• The combination of all advantages is possible through financing by means of participation capital with preferential rights: depending on the liquidity situation, deferral of compensation payments and no dilution of voting rights
• Konsento AG offers turnkey solutions for this and enables all administrative processes to be handled digitally via the Konsento platform.

High financing requirements due to the impact of Covid-19

The consequences of the coronavirus pandemic have led to an unprecedented economic slump: numerous companies have had to restrict or interrupt their business activities. This already led to a sharp decline in GDP in the first two quarters of 2020. According to the BAK Economics forecast from June 2020, gross domestic product (GDP) in Switzerland will fall by 5.8% in real terms in 2020 compared to the previous year. This is the sharpest economic downturn in the last 50 years. 

The Federal Council has put together a package of measures to cushion the economic impact, which includes liquidity support in the form of guaranteed COVID-19 bridging loans, short-time working, interest-free deferral of payments for social security contributions and the suspension of debt enforcement proceedings. These measures have initially relieved the economy. However, it is currently not possible to predict how the situation will develop. It is likely that companies with insufficient reserves in particular will increasingly run into payment difficulties in view of the difficult economic outlook. They will have to revise their business model and restructure their balance sheet in order to avoid going to the bankruptcy court. 

In addition to the state support measures already mentioned, there are other forms of financing that can bridge a liquidity bottleneck and support a company in its restructuring. However, they all have advantages and disadvantages. 

Advantages and disadvantages of debt financing

Borrowed capital burdens the income statement and, under certain circumstances, liquidity due to amortization and interest obligations. The amount of interest to be paid is determined by the company's credit rating, i.e. the higher the default risk, the higher the interest demanded by the lender. Debt capital also entails the risk of over-indebtedness. For companies that have got into difficulties due to the current economic situation, raising debt capital is therefore likely to be difficult or even impossible. 

Mezzanine capital is a form of debt financing that is subordinated to debt capital providers and given priority over pure equity. Mezzanine financing has a fixed basic interest rate and a performance-related component, such as a share of cash flow or sales (so-called profit-participating loans). This means that interest is also owed at fixed dates and rates for this form of financing. As these are loans, they also generally have to be repaid on a predetermined date. 

Both forms of debt financing take no or only limited account of the economic conditions prevailing on the respective payment date. In concrete terms, this means that interest or amortization payments are contractually owed, even if the company cannot (yet) afford them. 

Advantages and disadvantages of increasing the share capital

Classic equity financing through an increase in share capital mitigates the disadvantages of debt financing for the company: additional equity capital eliminates any under-balancing or over-indebtedness, especially if it is used to repay debt. The Annual General Meeting (AGM) decides on distributions to shareholders. This means that, unlike debt capital, equity capital does not oblige the company to make periodic, fixed payments to investors, which gives the company financial freedom in challenging times. 

However, as shares carry voting rights, the voting rights of the existing owners are diluted and the new shareholders exert external influence. The additional, interest-free capital is thus obtained at the price of independence. 

It is understandable that an entrepreneur does not want any external influence simply because he has found himself in financial difficulties due to the consequences of Covid-19 after having run his company successfully and independently for years. If the company needs to be restructured financially, the entrepreneur is faced with the fundamental question of whether he wants to accept high capital costs or even risk over-indebtedness by taking on debt capital or whether he wants to avoid this by taking on equity capital and accepting extensive participation rights from the new investors.  

However, current Swiss company law also recognizes instruments that combine an appropriate middle ground and thus the best of both forms of financing, provided that the interests of the entrepreneur and investor are properly aligned. 

Balanced interests through non-voting equity with preferential rights

In the case of public limited companies, they can raise participation capital instead of shares and issue participation certificates to investors in return. The participation capital is counted as equity and as such helps to restructure the balance sheet. As distributions on participation capital are subject to a resolution by the AGM, there is no obligation to make interest payments defined in advance. Furthermore, participation certificates do not grant voting rights and therefore avoid diluting the voting rights of existing owners.

As no fixed (interest) payments are planned, the investor must be compensated in some other way for the provision of capital and the risk taken. This can be done, for example, through preferential rights and, in particular, preferential dividends. For example, it can be stipulated that the existing owners of the company only receive a dividend once the investors with preferential rights have also received a dividend. Furthermore, the preferential dividend can be paid in a form that includes an additional Bonus and therefore higher Distribution exist.

The focus of interest is likely to be primarily on preferential rights to dividends. with right of subsequent subscription If the course of business does not (yet) permit the distribution of a dividend in one year, the dividend payment can be made up for cumulatively in the following years (so-called cumulative preferential dividend) as soon as the balance sheet profit permits this. The dividend payment is therefore not canceled for the investor with preferential rights, but is merely postponed and paid out at a later date together with the ordinary dividend. 

Such instruments give the company the flexibility to compensate the investor for its commitment when the economic situation has improved and the company can afford to make such payments without jeopardizing its continued existence. In return, the new investors are better compensated for the risk they have taken than the previous owners. 

In order to make raising capital even more attractive for investors, amendments should be made to the Articles of Association and covenants should be included in the investor agreements to compensate the participants for the lack of voting rights. These include information and disclosure rights, such as the right to participate (without voting rights) in the AGM as well as the right to information, the right of inspection and the right to submit motions. Further safeguarding clauses are also intended to prevent the privileges of the new investors from being undermined. 

Very few entrepreneurs will want to share profits with new investors in the long term and provide them with comprehensive information. At the same time, investors also want to aim for an exit in the medium term. For this reason, the investor agreements should also provide for an exit concept. However, this should also depend on the economic development and not on predetermined dates in order to give the company the necessary flexibility. 

Such instruments have advantages for companies, their existing owners and new investors. They help companies with financial bottlenecks but a viable business model to emerge from the current economic crisis in a sustainable manner. 

Konsento AG operates a digital platform on which turnkey corporate financing can be processed: from the online AGM with pre-formulated agenda items, amendments to the articles of association and investor agreements to the procurement of investors and capital through to the administrative processing of the capital increase. Contact us for a non-binding demo.