Meaning
Financial process of changing the categorization of a financial instrument from equity to debt or vice versa. Moving a balance sheet item can change a company’s leverage ratios and tax obligations. Equity reclassification often occurs when a regulator decides that preference shares function more like a loan due to fixed repayment terms.
Classification Treatment
The way an instrument is classified determines whether the payments made to holders are seen as dividends or interest. Dividends are paid from after-tax profit while interest is usually a tax-deductible expense. This distinction changes the net cash flow available to the company.
Conversion Trigger
Investment agreements specify the conditions under which a conversion happens (such as a failure to meet a milestone). When these conditions are met, the legal rights of the holder shift immediately. This change is then reflected in the next set of financial statements.
Liquidation Priority
Liquidation rights of the holder in an insolvency event shift based on whether the instrument is viewed as capital or a liability. Debt holders are paid before equity holders during the winding up of a business. This shift can significantly alter the recovery prospects for investors who find themselves demoted in the payment hierarchy.
A change in status often triggers a breach of separate loan covenants with third-party banks.
