Understanding Payment in Kind Loans

A payment in kind loan is a very risky type of debt with no interest or payments until maturity. There is a wide array of PIK loan structures, but all require payment in full upon maturity of the loan. Any interest accrued during the time period the loan is active is added to the principal debt or repaid when they loan reaches maturity. Most loans are for 5 years and do not require collateral, making them risky for the lender and expensive for the borrower. 

Benefits of a PIK loan

A lender does not extend this type of financing without the chance of significant benefits. With the lack of regular payments and collateral, the loan must present a good chance of profit for a lender to go through with the transaction. Profit is derived from arrangement fees, payment in kind during the life of the loan and a warrant attached to the loan. A warrant represents the lender's right to purchase a set number of shares of stock, at a set price from the borrower, within a specific period. 

PIK interest payments

Since a borrower makes no actual cash interest payments while the loan is active, the question of how interest will accumulate is relevant. Typically, interest can be added to the principal debt. This is done through the primary structures mentioned above, including high assessment fees and warrants for stock. Essentially, the payments are arranged through a method other than cash, but the lender is still getting paid for extending the loan to the borrower. However, the borrower also benefits, because the loans are highly flexible, typically may be refinanced very easily, and the interest is always tax deductible.

PIK loan toggles

Loan toggles are a unique interest payment option. When interest comes due on a PIK loan, the borrower has the option of making at least a partial payment in kind. This means the borrower can offer stock or equity rather than cash for the payment. When a borrower toggles the loan in this way, the lender exercises its option to then raise the interest rate on the debt substantially. The resulting structure is a highly variable rate of payment whereby both parties can decide to change payment terms midway through the debt.

When to use a PIK loan

Taking a PIK loan is complicated, risky and expensive. Banks will not typically offer this type of loan. Typically, you will need to find an investor or mezzanine lender to finance your risk. These third party lenders are not regulated to the same degree as a bank. They will often ask for equity in your business in return for the loan. Because of these drawbacks, is best to only seek this loan structure if you have considered other options first and determine a PIK loan suits your needs best. For example, some businesses will need investor financing to build their balance sheets and secure larger debts. By taking a PIK loan from an investor, you can add to your working capital, giving you a better chance at increasing revenue and securing other loans.

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