Recapitalization

What is a recapitalization?

Recapitalization (German: Rekapitalisierung, restructuring of the capital structure) describes a measure by which a company fundamentally reorders its financing. This concerns either the ratio of equity, that is, the funds of the shareholders, to debt, that is, the liabilities, or the distribution of the equity among the shareholders. The company itself remains the same; what changes is who is entitled to which part and to whom it owes how much. In practice the measure is called a recap for short.

Three forms are typical. In a capital cut (Kapitalschnitt), the share capital is first reduced and then increased again through new contributions. In the conversion of receivables into equity (debt-to-equity swap), a creditor receives shares in return for its claim. In a debt-financed distribution (dividend recap), the company takes out a loan and pays the money out to the shareholders.

The occasions are opposite. In a crisis, a recapitalization serves to offset losses on the balance sheet, reduce debt and make the company financeable again for new investors. In highly profitable companies, it serves to return capital to the shareholders, above all in investment companies that acquire majority stakes in mature companies (private equity). It is implemented by shareholder resolutions, amendments to the articles of association and contracts with creditors, in insolvency and restructuring also by an insolvency or restructuring plan. For banks and insurers, recapitalization usually means the injection of new equity to meet regulatory minimum capital requirements, in crises also by the state.

Capital cut: reduction and new contributions

A capital cut combines a capital reduction with a subsequent capital increase. The reason lies in a fixed lower limit: new shares may not be issued below their nominal amount. If the value of the company per euro of share capital is below one euro, a round at the negotiated price is possible only after a reduction. At the same time, the balance sheet is cleaned up, because the reduction amount offsets losses.

In restructuring, the simplified capital reduction under Sections 58a et seq. of the German Limited Liability Companies Act (GmbH-Gesetz, GmbHG) is used. It is a purely bookkeeping operation to offset impairments and losses; payments to shareholders are excluded. Beforehand, capital and revenue reserves must be released to the extent that together they exceed 10% of the share capital remaining after the reduction, and there may be no profit carried forward (Section 58a(2) GmbHG). A creditor notice with a one-year blocking period (Sperrjahr) as in the ordinary capital reduction under Section 58 GmbHG does not apply.

The share capital may fall below EUR 25,000 only if a capital increase resolved at the same time with cash contributions brings it back to at least this amount. The resolutions are void if they are not registered within three months (Section 58a(4) GmbHG). In this combination, a reduction to zero is also possible, in which the existing shareholders remain shareholders only to the extent that they participate in the increase. Both resolutions need three quarters of the votes cast and notarial recording. Each share must be in whole euros even after the reduction.

Conversion of receivables into equity (debt-to-equity swap)

In the conversion, a creditor contributes its claim against the company as a contribution in kind to a capital increase and receives new shares in return; the claim expires. What matters is its actual value, not its nominal amount, and in a crisis this is often considerably lower. If it does not cover the nominal amount of the new shares, the contributor is liable for the difference (Section 9 in conjunction with Section 56(2) GmbHG). A cash contribution that flows back shortly afterwards to repay the same claim can be treated as a hidden contribution in kind (Section 19(4) GmbHG).

In growth companies, the conversion mainly concerns shareholder loans and convertible loans of existing investors. Milder alternatives leave the shareholdings unchanged. A qualified subordination (Rangrücktritt), by which the creditor ranks behind all other creditors, takes a shareholder loan out of the over-indebtedness test (Section 19(2) sentence 2 of the German Insolvency Code, Insolvenzordnung, InsO; see Subordinated Liabilities). A debt waiver with a recovery clause (Besserungsschein) lets the claim revive on future profits. In an insolvency plan, conversion is possible under Section 225a InsO, but not against the will of the creditor.

Debt-financed distribution (dividend recap)

In a dividend recap, the company distributes newly borrowed debt to the shareholders or uses it to repay shareholder loans. This is common in private equity holdings, to return capital to the investors before the exit. As the debt ratio rises, so do the requirements on debt service capacity and on compliance with covenants.

Legally, the assets required to maintain the share capital may not be paid out to shareholders (Section 30 GmbHG). The management is liable for payments to shareholders that were bound to lead to insolvency (Section 15b(5) InsO), and distributions can under certain circumstances be challenged in a later insolvency. For tax purposes, the interest barrier rule (Zinsschranke), a cap on the deduction of interest expense, limits the deductibility of interest (Section 4h of the German Income Tax Act, Einkommensteuergesetz, EStG; Section 8a of the German Corporate Income Tax Act, Körperschaftsteuergesetz, KStG). For growth companies with losses, a dividend recap generally does not come into consideration.

Reordering of preferential rights in venture financing

In venture-financed companies, recapitalization often denotes the reordering of the preferences when their sum exceeds the achievable enterprise value and new investors will come in only on this condition. Earlier preferences are reduced or cancelled, existing investors keep their rights only if they take part in the new round (Pay-to-Play), and a new participation programme binds the team. If the round is carried out at the same time at a sharply reduced price per share (down round), this is called a cramdown.

A special right anchored in the articles of association can generally be cancelled only with the consent of its holder. The shareholders' agreement can be amended only with the consent of all contracting parties, unless it provides for amendment by majority resolution. Negotiation with the existing investors is therefore the real bottleneck of such a reordering.

Tax consequences of a recapitalization

If a creditor waives a claim, taxable income in principle arises at the company. If the creditor is also a shareholder, this applies only to the part of the claim that is not recoverable; the recoverable part is treated as a contribution. The same applies where a claim is converted into equity: to the extent that it is not recoverable, income arises. Under Section 3a EStG, which also applies to the GmbH through corporate income tax law, such a restructuring gain is tax-exempt under strict conditions. What must be shown is the need for restructuring, the viability of the company, the suitability of the waiver for restructuring and the restructuring intent of the creditors; a corresponding rule applies for trade tax. In return, loss carry-forwards and other tax reduction items lapse to a corresponding extent.

If more than 50% of the shares shift to an acquirer within five years, losses not yet used can in principle no longer be deducted under Section 8c KStG. Capital increases count to the extent that they change the shareholding percentages. Whether the going-concern-linked loss carry-forward under Section 8d KStG or another exception applies belongs in the tax review before the resolution is passed. The simplified capital reduction itself triggers no tax for the shareholders, because nothing is paid out.

Worked example: capital cut with debt-to-equity swap

A GmbH has share capital of EUR 1 million; the founders hold shares with a nominal amount of EUR 600,000 (60%), investor A EUR 400,000 (40%). No reserves remain, and the balance sheet loss is EUR 3.4 million. The shares have round nominal amounts that are divisible by ten. A has also granted a shareholder loan of EUR 1.5 million. A new investor N offers EUR 2 million for 50% of the shares if A converts its loan into equity at the same price. The pre-money valuation of the existing shares is EUR 500,000.

• Price without a capital cut: EUR 500,000 / EUR 1,000,000 nominal amount = EUR 0.50 per euro of nominal amount. This is below the nominal amount and impermissible.
• Simplified capital reduction to one tenth: share capital EUR 100,000, founders EUR 60,000, A EUR 40,000. The reduction offsets EUR 900,000 of the balance sheet loss, leaving EUR 2.5 million.
• New price: EUR 500,000 / EUR 100,000 = EUR 5 per euro of nominal amount.
• Conversion of the loan: EUR 1,500,000 / EUR 5 = EUR 300,000 of new nominal amount for A. The claim must cover at least this nominal amount in recoverable value.
• N's cash contribution: EUR 2,000,000 / EUR 5 = EUR 400,000 of nominal amount, plus EUR 1.6 million of premium.
• Result: share capital EUR 800,000. N holds EUR 400,000 (50%), A EUR 340,000 (42.5%), the founders EUR 60,000 (7.5%).

The post-money valuation is 800,000 × EUR 5 = EUR 4 million, that is, EUR 0.5 million of existing shares plus EUR 1.5 million of converted claim plus EUR 2 million of new capital. The liability of EUR 1.5 million falls away, and the company receives EUR 2 million of additional liquidity. The founders fall from 60% to 7.5%; in this situation new investors often demand a participation programme that gives the founders and management a stake in future value growth again.

Distinctions: recapitalization, cramdown and capital increase

• Cramdown: a funding round at a sharply reduced valuation or the outvoting of groups in a plan, often one building block of a recapitalization.
• Capital increase: a single capital measure. A recapitalization usually combines it with a reduction, a conversion or the reordering of rights.
• Qualified subordination (Rangrücktritt): improves the over-indebtedness test but leaves the claim and shareholdings in place.

Common mistakes

• Started too late. Once liquidity is exhausted, often only insolvency remains instead of a reordering, and the negotiating position of the existing shareholders is lost.
• Nominal amount limit overlooked. A negotiated price below EUR 1 per euro of nominal amount cannot be implemented without a prior capital cut.
• Claims taken at nominal value. An overvalued contribution in kind leads to liability of the contributor for the difference and can delay registration.
• Team not considered. A reordering that dilutes founders and management to a fraction without setting new incentives endangers the continuation of the business.

Frequently asked questions

What does recapitalization mean in private equity?

Usually a debt-financed distribution (dividend recap, also leveraged recap). The portfolio company takes out new loans and distributes them to the investment company. This improves its return, because part of the capital flows back before the sale. In return, debt rises, and a later buyer checks in due diligence whether the debt service is sustainable.

Do shareholders lose their shareholding in a capital cut?

Not necessarily. The reduction affects all shareholders in the same proportion; how strongly their stake then falls depends on whether they take part in the subsequent capital increase.

Is a debt waiver taxable?

In principle yes, as income of the company. It can be tax-exempt under Section 3a EStG if the conditions of a company-related restructuring are shown; the loss carry-forwards are then reduced at the same time.

Does a recapitalization need the consent of all shareholders?

Not always. Capital reduction and capital increase require three quarters of the votes cast. The cancellation of special rights and amendments to the shareholders' agreement, by contrast, mostly presuppose the consent of those affected; in an insolvency or restructuring plan, shareholders can be outvoted under the statutory conditions.

The Roemer Capital view

A recapitalization is first of all a legal and tax measure for which the company's law firm and tax adviser are responsible. The contribution of Roemer Capital begins when it is combined with a funding round. Roemer Capital builds the financial model with a base, a conservative and an optimistic case, calculates stakes and preferences before and after the measure and prepares the talks with new investors.

The yardstick of Roemer Capital is whether the company is afterwards investable again, that is, structurally able to grow disproportionately with external capital. A reordering that only cleans up the balance sheet but leaves team and governance unresolved does not meet this yardstick.