Is It Debt or Equity?

A few years ago, a management team completed a seller-financed leveraged buyout. Last year the company had a very good year ( and the shareholders decided to contribute their annual bonuses back to the company. They invested the money in a certificate of deposit. They agreed in writing that the funds would be reserved for “(1) paying debt still owed to (the seller) or (2) emergency company use” and that none of them “could withdraw any money contributed”. They accounted for the transaction as an asset (the CD) and a (current) liability. When their accountant prepared their annual financial statements, and during my valuation, the question arose as to whether this transaction created debt (a liability of the Company) or equity (either paid-in surplus or more stock shares). After discussion, it was concluded that the transaction created additional equity due to the contributors’ inability to withdraw the funds, which eliminated the justification for it being a liability. It was also concluded that the transaction created new shares of stock, not paid-in surplus, because the seller (who retired once the buyout closed) retained an equity interest and did not contribute capital. It would have been unfair to the contributors not to receive benefit in the form of increased shares (and for the seller to get an increase in his book equity) as a result of the capital contribution. Fortunately, everybody agreed to this. This raised a bigger question for me: what is the definition of equity as opposed to debt? I am not an accountant, and have not been able to research what the regulatory authorities say about this. (Anyone who knows, please let me know, and I will publish the results.) I Googled the subject and found something at: http://pages.stern.nyu.edu/~igiddy/articles/moodys_hybrids.pdf Although dated 2003 and somewhat technical, this Moody’s publication contained (on page 2, under the “Background…” section) a clear and, at least to me, very useful definition of the characteristics of pure equity: 1. No maturity 2. No ongoing payments that could trigger a default if unpaid 3. Loss absorption for all creditors In other words, pure equity has no principal due date, no ongoing payments, and is paid only after all creditors are satisfied. I infer from this that anything that doesn’t meet these criteria has elements of debt. I checked it with the above problem, and it worked out perfectly, telling me that the subject money should be treated as equity. The rest of the Moody’s paper, which was interesting but not overly relevant to us, describes how they developed a continuum to classify “hybrid” securities that have elements of both debt and equity, and how they place them in different “baskets” with different percentages of debt and equity allocated for purposes of financial ratio analysis. This is subjective, and gets into issues such as how subordinated (to senior debt obligations) a hybrid security might be, whether dividends can be deferred, how much financial flexibility the security provides, the impact of call options and conversion features, liquidation preferences, and how they might evolve over time in terms of the issuer’s ability to pay dividends / interest and principal under different scenarios. This sounds a lot like business valuation to me, but from a debt rather than an equity perspective…and now I can tell the difference!