Sometimes, conventional loans just don’t work for a business. Sales are booming and every penny is needed to finance the buildup in inventory and receivables and to buy more equipment. To fund this growth, businesses could take out short-term working capital loans, but the recurring payments against principal and interest cut into cash flow, stunting profitable growth.
Is there an alternative? Yes, there is. It’s called a payment-in-kind or PIK loan.
What Is a Payment-in-Kind Loan?
PIK loans are attractive to businesses that don’t want to make payments on principal and interest, preferring to conserve internal cash flow to finance rapid growth.
Most traditional loans require borrowers to make regular payments of principal and interest on a fixed schedule. PIK loans don’t have these requirements. Instead, borrowers make interest “payments” on PIK loans by issuing securities in lieu of cash. Payment could be in the form of stock options, stock warrants or additional securities that allow investors to share in the future success of the company.
How Does a PIK Loan Work?
With PIK loans, the borrower does not make any cash payments of principal or interest between the drawdown date and the maturation date. Usually calculated on a compounding schedule, interest accrues and is either added to the principal balance of the loan or “paid” by the issuance of new securities. Refinancing during the early years of the loan is either prohibited, highly restricted or comes with a substantial cost.
Banks are not usually sources for PIK loans. Pay-in-kind financing is more suitable for investors looking for higher returns, who are willing to assume the increased risk.
Maturities of PIK financing typically exceed 5 years. They are normally unsecured, are not based on any specific assets and are subordinated to other senior debts of the company. Because of these characteristics, PIK loans are often considered a form of “mezzanine financing.” They fill the gap between secured senior debt obligations and equity and have features of both.
The Cost of In-Kind Payment Agreements
A PIK note costs more to repay than traditional forms of debt financing. But when compared to equity investments, they’re generally less expensive. Lenders require higher rates of return on PIK loans because of the risk they’re taking on. PIK loans are not secured with collateral, borrowers do not pay interest in cash until maturation and periodic principal payments are not required. The credit risk of a PIK loan actually increases over time, as the loan balance rises with the addition of unpaid accrued interest.
What are the Different Types of PIK Loan?
The three types of PIK loans are as follows:
True Payment-in-Kind Loan
This is the simplest form of a PIK. Interest is paid with the issuance of in-kind securities and warrants. The principal amount of the loan and the accrued interest must all be paid at maturity. The warrants give the investor the opportunity to benefit from the success of the business.
In this case, the borrower pays a portion of the interest in cash if specific payment criteria are met. This could be the result of payment restrictions imposed on the company by senior debt covenants that prohibit cash payments on the PIK loan. If the borrower is unable to meet these restrictions, interest payments on the PIK loan are made with other securities per the agreement.
With a “toggle” agreement, the borrower has the choice of whether to make payments in cash or in-kind. This feature gives the borrower the option of making or not making cash interest payments as necessary, depending on available cash flow. Non-cash interest payments could be made by offering a form of stock or equity.
However, if the borrower elects to use the toggle feature, the lender will have the option to substantially increase the interest rate.
While most PIK loans fall into these categories, it should be noted that PIKs are flexible and can be modified to meet a borrower’s specific needs.
How are Lenders Compensated for PIK Loans?
Investors in PIK loans receive a return from three sources:
- Arrangement fee: A fee for putting the loan agreement together is usually paid upfront. It covers the administrative costs of PIK financing.
- Payment-in-kind interest: Interest on the loan is significantly higher than conventional borrowings because of the increased risk. Accrued interest is added to the principal of the loan and is compounded, adding to the total return.
- Warrants: Stock warrants issued by the company give the investor the right to purchase shares of stock at a lower price. This is a way for the investor to reap the rewards of the profitable and successful growth of the company.
How Can Businesses Use PIK Loans?
Small- to medium-size businesses can use PIK loans to finance their operations during periods of rapid growth when they wish to conserve cash outflows. A company can increase its borrowing capacity by using PIK loans. It allows the business to carry more debt since PIK loans do not put any pressure on the company’s cash flow because the loans do not require interest or principal payments.
PIK loans are more flexible than other debt instruments that might pigeonhole how your business uses the funding.
Funds from payment-in-kind loans can be used for capital expenditures, to finance growth in working capital or fund the expansion of marketing and sales campaigns for new products.
PIKs are also suitable for products that take longer to develop and bring to market. These types of products consume large sums of cash in the beginning development stages but have significant possibilities of long-term returns.
An added benefit is that the interest payments are tax-deductible. In most cases, the accrued interest can be expensed on the company’s profit and loss statement, creating a tax shield.
Example of a Payment-in-Kind Loan
Let’s take a look at an example of how a payment-in-kind loan is structured.
Suppose a borrower takes a PIK loan for $3 million with a cash interest rate of 14 percent and a PIK interest of 3 percent. In this scenario, no warrants or other securities are attached to this loan. The loan must be paid in full in 5 years together with any outstanding interest.
At the end of the first year, the current interest of $420,000 (14 percent of $3 million) gets paid in cash, and the PIK interest of $90,000 (3 percent times $3 million) is added to the balance, increasing it to $3,090,000.
The cash interest paid for the second year is $432,600 (14 percent times $3,090,000) and the PIK interest is $92,700 (3 percent times $3,090,000). The balance then gets increased to $3,182,700 ($3,090,000 plus $92,700).
PIK interest is compounded and continues to accumulate and get added to the principal of the loan. The total principal and any PIK interest that accrues get paid at the 5-year maturity date.
Are Payment-in-Kind Loans Right For Your Small Business?
Payment-in-kind loans are expensive but may be an attractive option for startup businesses or companies experiencing rapid growth. Not having to make principal and cash interest payments during the loan’s term frees up capital that can be used to finance growth in current assets, purchase building and equipment or even fund the takeover of a competitor.