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Debt and Equity - GermanyAbout this Practice Area
Debt and Equity Definition
With respect to corporate financing there are two main strategies to capitalize a company: debt & equity. Both terms refer to the origin of capital on the balance sheet.
Equity describes the amount of funds contributed by the owners (the shareholders) plus the retained earnings (or losses). Equity is further identified as common stock with regard to the funds which match the registered capital and as additional paid-in capital where it exceeds the registered capital. The real advantage of equity financing is the possibility of a company to acquire funds without incurring debt: The purchasers of equity instruments (i.e. stocks/shares) do not gain repayment and/or interest payment claims against the company, but an ownership interest and therefore participate in the company’s future profits and risks. This participation can be realized by selling the stocks/shares on a secondary market (which may be either regulated or not) and/or – potentially – through dividend payments.
Debt characterizes the borrowing of money by one party from another which has to be repaid, usually with interest (e.g. bank facilities, loans or bonds). Debt instruments do neither grant an ownership interest nor do the respective creditors participate in the company’s future profits, but can solely claim the aforementioned (re-)payments. Debt instruments are deemed to be less risky for investors, since their claims rank prior to the ownership interest of shareholders in case of insolvency proceedings. Within the debt instruments the seniority varies between secured debt – i.e. debt backed by assets – and unsecured debt.
Notwithstanding the above mentioned, a clear distinction between debt and equity is not always possible, since mezzanine instruments combine elements of both. (Non-exhaustive) Examples are options and warrants which enable the creditor to convert debt-claims into ownership (i.e. shares) under certain circumstances and shareholder loans which constitute repayment claims, but are often subordinated in German insolvency proceedings. The dividing line between debt and equity is also blurred by legal provisions which allow for a (non-)coercive debt-equity-swap (cf. the respective provisions of the German Debenture Bond Act (SchVG) and the German Insolvency Code (InsO)). Ultimately, even preferred equity combines elements of both debt and equity as preferred stockholders benefit from a fixed dividend but generally are subordinated to creditors.
The areas of legal advice with regard debt & equity basically comprise all transaction related activities, from financings to mergers & acquisitions and eventually to restructurings.
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