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Sample Article from the May-June 2013 Issue:
Paid-in-Kind Interest in ESOP TransactionsBy Mary Josephs and Neal Hawkins, Verit Advisors
In the earlier years of ESOPs, particularly before the advent of S corporation ESOPs, sellers bridged the gap between the company's enterprise value and its debt capacity by doing transactions in which the ESOP acquired only some percentage of the shares. The size of the ESOP could more or less be determined by debt capacity.
While executing a smaller ESOP remains a solid strategy, many companies are now evaluating the feasibility of becoming 100% ESOP-owned in a single transaction. It is very improbable to finance a non-ESOP company electing to pursue a 100% ESOP entirely with third-party debt, so ESOP transactions now often involve having the selling shareholder provide financing through a deeply subordinated note.
For the note holder, the all-in return comes from two separate components: interest and warrants. The interest is the fixed part of the return, while the warrant provides a variable and more risky return, as it is tied to the future equity growth. This article focuses on the interest portion of the note, and specifically on the implication of interest that is paid in kind.
Paid-in-kind (PIK) interest is interest that is accrued to the principal instead of being paid in cash. In other words, PIK interest is added to the outstanding loan balance and is paid at maturity. PIK interest is commonly used to provide a company with cash flow flexibility, minimizing the required cash need on the company in the near-term in exchange for payment at a later period. PIK interest can apply either to the entire rate charged or, more frequently, to a portion of the interest. For example, an interest rate on a seller note might be 10%, of which 3% is cash and 7% is PIK.
While the increased flexibility of using PIK interest over traditional current-pay interest is attractive, it does come at a cost to the company and the selling shareholder. The company should understand, through longer-term capital analysis, the total cost that can, unfettered, exceed the future debt capacity of the company, suppress value accretion for the ESOP, and ultimately force a sale or liquidation. The figure below shows the impact of compounding interest from PIK interest compared to cash interest over a 10-year period.
The figure below shows that over a 10-year period the 7% PIK interest will compound dramatically, with the balance of the seller note increasing from $10 million to more than $18.4 million. To provide some context, if the PIK rate were increased by 3% to 10%, the principal balance of the seller note would grow to $23.6 million, more than 2.4 times the original seller note balance for the 10-year period. This is the power of compounding interest that needs to be considered when using PIK interest.
If PIK interest is 7% and cash interest is at 3%, over a 10-year period payments will amount to $13.8 million ($9.67 million in PIK interest and $4.14 million in cash interest). That is $3.8 million more than the cumulative cash interest paid would be with a 10% straight cash interest payment. The additional $3.8 million might not seem like a lot at first blush, but that is value not being allocated to ESOP participant accounts. A trustee will also calculate the effective interest rate (or the annual interest rate based upon the total amount of interest over the life of the loan) for the loan based upon the total amount of cash and PIK interest paid, which in this case would have been 13.8%.
Companies should understand and weigh the benefits and considerations of using PIK interest with a seller note. If a default occurs, a senior lender will require any cash interest paid on the seller financing to instead be paid in PIK until such time as the borrower emerges from default. Absent care and thoughtful planning at the outset, PIK interest could significantly decrease ESOP benefits.