Recapitalization
Recapitalization is the process of programmatically transferring ownership from the former equity holders, who failed to uphold obligatory payment, to creditors, who become the new owners. One could also call this "programmatic bankruptcy." After recapitalization, the company has no debt. All debt will be converted to preferred equity. Before recapitalization, a company becomes delinquent and has a grace period where it has the opportunity to return to make creditors whole.
Recapitalization has two phases:
Delinquency - a precursor grace period of 90 days
Restructuring of the company such that debtholders become the new owners
Delinquency
Before a company is recapitalized, there a company enters delinquency. During this 90-day grace period, a company has the opportunity to repay obligations.
Delinquent refers to a company that misses either the principal or interest payments on its debt. A company can only exit delinquency through repayment (and return to good-standing) or recapitalization.
Grace Period
During the grace period, the company can catch up on obligatory payments by obtaining cash to fulfill obligations to creditors. A company may do this in a variety of ways:
Raise money via new equity financing or debt financing
Sell illiquid assets
Exchanging liquid assets for the company's denomination asset, which can be used to pay back creditors
Consequences of Continued Delinquency
If the company is unable to become solvent during the grace period, the company is recapitalized. The equity holders lose control of the company and the debtholders assume control. Any remaining amount of the denomination asset is used to pay out the company's most senior debt holders. Repayment of debt is made per seniority level. All equity owners are wiped out during this restructuring.
Assume that the below is company Foo's capital stack:
Foo has enough of its denomination asset to make holders of debt asset F whole by repaying their principal and interest. However, Foo can only repay debt asset D's and a partial amount of E. Under this scenario, D and E are not paid any assets but, rather, are given preferred shares following Foo's restructuring.
Creditors will be given ownership that’s directly proportional to the amount of debt that they were owed in the form of preferred shares. Each dollar of debt will convert to one share of preferred equity in the recapitalized company. The voting weight and liquidation preference value of each preferred share class will be one. For example, if Alice owned $1,000 of debt, she would subsequently own 1,000 preferred shares with a liquidation preference of $1,000 and have 1,000 votes in governance.
The preferred shares will have a seniority structure identical to the seniority structure of the debt. The most senior debt that was unable to be paid in full converts to the most senior preferred equity. This assures that the effect of seniority is preserved if the new shareholders choose to liquidate the company and return capital to shareholders.
Once recapitalized, the new shareholders must select a new board. If not set to Late Stage Governance, the governance system is automatically changed to Late Stage Governance, giving the shareholders ultimate control over the company. The company will resume normal operations once the board has been deemed ready. If desired, the new shareholders may immediately liquidate the recapitalized company via governance. However, shareholders will likely sell any remaining illiquid assets or even the recapitalized company, itself, before liquidating.
After Recapitalization
The new shareholders may choose one of two paths:
Raise money and continue operations as the new owners
Liquidate whatever minimal assets remain
A company may have had illiquid assets or non-denomination assets that can be converted to the treasury's denomination and returned to the new shareholders during liquidation.
Avoiding Delinquency
There are two ways to avoid delinquency.
A company can never enter delinquency if it never takes on any debt.
A company will never enter delinquency if it stays up to date on all payments. Since the payment of debt and interest is deterministic, the company must manage cash flows and stay up to date on obligations.
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