Comparing cash vs. PIK interest when financing a business acquisition

A key aspect in an SMB acquisition is how to finance the deal. For many small businesses, buyers will use a mix of SBA debt, investor equity and seller financing. As the deal size gets larger, the financing options often get more creative.

Although the SBA program is quite popular, one of the drawbacks is that the loan size is capped at $5M. This means that if you need more than $5M of debt from a lender, you'll need to pursue other options.

As you go up-market, the debt structures can become more custom and bespoke. You may be negotiating with an SBIC fund or a private lender. These lenders will often include PIK interest in their term sheets (PIK stands for paid-in-kind), and it will likely be the first time many SMB entrepreneurs hear of PIK interest.

This article should give you a quick walkthrough of PIK interest and how it is different than cash interest.

What is PIK Interest?

PIK interest refers to interest that is “paid-in-kind”. Unlike cash interest, which is paid in cash to a lender or SBA bank, PIK interest is “cashless” interest that accrues on the principal balance. Rather than paying it as cash, you add it to the balance, at which point you owe the PIK interest plus the existing principal balance to the lender.

So that leads to a natural question, when would an entrepreneur see PIK interest? If the entrepreneur is an independent sponsor or self-funded searcher sourcing debt for larger deals, there’s a decent chance they will find themselves with term sheets including PIK interest. PIK interest is particularly common from private lenders and Small Business Investment Company (SBIC) funds.

Depending on the exact structure of PIK financing or debt financing, the financing structure may have a built-in PIK toggle whereby it gives the borrower the option to delay cash interest payments and turn traditional debt financing into PIK financing.

Advantages of PIK Financing

An advantage to PIK financing is that it allows a company to lower its immediate cash flow requirements by allowing interest payments to accrue instead of having to be paid in cash for that given year. In other words, it is a great tool to help businesses manage their liquidity. PIK financing benefits start-ups because of their lack of cash (with start-ups there is a strong emphasis on growth) or companies in dire need of liquidity. 

Another advantage is that PIK financing is typically unsecured (mezzanine financing) so no collateral is needed for the loan. Plus, PIK financing gives a company more control and flexibility in when cash payments are due. Instead of having all interest due as cash, entrepreneurs can decide to make early repayments or defer and allow the PIK to accrue for later payment.

Disadvantages of PIK Financing

A disadvantage of PIK financing is that it often comes with higher interest rates compared to traditional debt financing. Economically, from a lender's perspective, this makes sense because the lender is essentially giving up today’s cash interest payment for tomorrow’s cash interest payment.

Another disadvantage is that as interest is accruing that interest compounds, which leads to significant debt service payments in the future. The other downside to PIK financing is that it may allow companies to defer cash payments when it is not best for them to do so. In other words, if a company is struggling to pay its debt because it is near bankruptcy then a PIK financing structure could be prolonging the inevitable bankruptcy.

It's very important to have a path towards early repayments or refinancing of the debt when using PIK interest.

PIK Financing Excel Walkthrough

Below is an example of a PIK loan from an SBIC fund. With this loan specifically, the loan is going to require an 11% annual interest rate for its cash payment plus a 1.5% monthly interest rate for its PIK interest. These loan terms are determined by a multitude of variables including the type of the industry the business operates in, credit history, financial history, etc. Pay particular attention to the PIK interest column and how that is calculated.

The PIK interest is calculated by taking the PIK interest rate (1.5%) and multiplying it by the beginning balance. This is how the PK interest column is calculated through the 24 months shown above. 

The beginning balance for a given month is simply the prior month’s ending balance and that is calculated as the beginning balance minus early repayment minus amortization plus PK interest. In the above example, the beginning balance for the second month is calculated at $5,500,000 - $0 - $50,000 + $82,500 = $5,532,500.

Mandatory Payments Excel Walkthrough

While this is the same PIK loan as the last example, in this section pay particular attention to the amortization and due in a year columns.

The due in a year column is what would be referred to as the mandatory payments in the PIK financing documents. In this example, year 1 will have a mandatory principal payment of $600,000. Therefore, monthly amortization will be $50,000. The same calculation is had for the mandatory principal payment in year 2, $900,000.

As a quick comparison, traditional financing for this firm would more than likely garner an annual interest rate of 14% (no PIK interest); therefore, the traditional financing option would increase the cash interest paid by the borrower. However, if the business has cash flow issues, the PIK financing option may be preferred because the PIK interest is deferred and thus the cash interest payment is less than the cash interest payment with traditional financing.

Concepts to Remember for PIK Financing

There are a few important concepts to know once the loan documents have been signed for PIK financing. One, it is incredibly important to make early repayments of debt because this will lower the amount of interest accrued and diminish the effects of compound interest. In addition, pay attention to the loan documents for PIK financing because some lenders (Private or SBIC funds) may require annual mandatory payments to decrease principal. For example, the loan documents could state that $600,000 of principal must be repaid by the end of year 1.

Lastly, economically speaking, PIK financing tends to make the most sense for private equity deals (leveraged or management buyouts) because returns are expected to be high compared to the PIK interest that is charged. However, that doesn’t mean that PIK financing is only for private equity deals. It is important to consider every financing option for a deal before signing anything.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.