More often than not, a key ingredient in turning around a deeply troubled yet highly promising company is the restructuring of its multitiered debt. But few chief executives have attempted as drastic a restructuring as Bobby Kotick did. He's the CEO and part owner of $40-million Activision, a Los Angeles-based licensee of Sega and Nintendo action games. Kotick's strategy -- to persuade most of Activision's creditors to swap existing debt for equity stakes -- transfigured his company, and it also demonstrates that equity, rather than debt, is frequently a better financing option for a growing business because it creates so many fewer demands.

Kotick's story dates back to the early 1990s, when he and four partners spent $500,000 to acquire a 25% stake in Activision, then logging about $60 million in sales. "We knew that the company was basically insolvent because it had lost a patent-infringement case," Kotick recalls, "but we didn't know just how insolvent it was." With the company's debt records in disarray, it took Kotick and his partners some time to figure out that "Activision owed its bankers and trade creditors so much that we would have had to come up with $25 million just to get to ground zero and then start all the other things we needed to do to turn the company around."

Kotick was convinced that so much debt would bury Activision's prospects for restoration to good health. "There was no money in the company to make interest payments, let alone to ever pay off the principal," he notes. The debt-to-common-stock conversion was the only solution. "We couldn't offer our debt holders even a long-term note, because we couldn't service any kind of debt."

The deal Kotick offered turned all existing debt into a stake that represented about 50% of Activision's stock. As proposed, the stock would be a pure growth play for the company's former debt holders, since there would be no owner dividends. (Kotick did not want to replace one type of payment obligation with another.)

The 25% stake originally purchased by Kotick and his partners "was reduced to one-half of 1% of the newly configured company," he says, explaining that "it was important for our creditors to see that we were making significant concessions, too." Most of Activision's creditors agreed with Kotick's basic pitch: "Their choices were either to write the debt off and get nothing out of it or to write it off, take the stock, and hope that if the company started growing profitably, the stock would increase in value and they would eventually recoup their investment."

Still, there was one holdout, a venture-capital firm that refused to participate in the equity-for-debt swap. "We begged them to go along with the deal. We told them that they were disrupting the whole process, but they wouldn't do it," the CEO recalls. Finally, Kotick and his partners bought out the venture capitalist's investment for $375,000. "We used our personal resources as well as collateral from our other business holdings to help Activision secure a new, large line of bank credit." Kotick and his partners ended up holding about one-third of Activision's new stock.

The debt-to-equity swap was effected as part of a prepackaged bankruptcy proceeding that lasted 45 days and cost the company about $750,000 in legal fees. But it was well worth it, concludes Kotick. "Before we did the deal, we had $25 million in claims against us and a market value of $2 million. Now we have only a small amount of debt, and our stock is worth about $90 million. We could never have accomplished that if we were still weighed down with all that debt. The swap enabled our company to have a future."