Payment-in-Kind (PIK): What It Is, How It Works, Pros and Cons

What Is Payment-in-Kind (PIK)?

Payment-in-kind (PIK) is the use of a good or service as payment instead of cash. Payment-in-kind also refers to a financial instrument that pays interest or dividends to investors of bonds, notes, or preferred stock with additional securities or equity instead of cash. Payment-in-kind securities are attractive to companies preferring not to make cash outlays and they are often used in leveraged buyouts.

Key Takeaways

  • Payment-in-kind (PIK) is the use of a good or service as payment or compensation instead of cash.
  • Payment-in-kind debt instruments call for interest payments that may be paid in cash or non-cash assessments.
  • Though payment-in-kind agreements help a company preserve its cash, the company often faces higher interest assessments that may be added to its principal balance or dilute its shareholder equity.
  • The phrase "payment-in-kind" also applies to the accepting of cash alternatives for work or services.
  • The Internal Revenue Service (IRS) refers to payment-in-kind as bartering income and it requires people who receive income through bartering to report it on their income tax returns.
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Payment-In-Kind

Understanding Payment-in-Kind (PIK)

Payment-in-kind securities are a type of mezzanine financing, where they have characteristics indicative of debt and equities. They tend to pay a relatively high rate of interest but are considered risky. Investors who can afford to take above-average risks, such as private equity investors and hedge fund managers, are most likely to invest in payment-in-kind securities.

Payment-in-kind notes give the issuer a chance to delay making dividend payments in cash and return for the delay, the issuing company typically agrees to offer a higher rate of return on the note.

In most cases, PIK notes compromise a fraction of a company's total outstanding debts, and the financier structures these notes so they mature later than the company's other debts. This allows the company to focus on repaying traditional debts or debts tied to cash dividends more quickly, but it adds additional risk to the financier. To cover their risk, most financiers stipulate an early payment penalty to maximize their potential earnings.

The phrase "payment-in-kind" also applies to accepting cash alternatives for work or services. For example, a farmhand who is given "free" room and board instead of receiving an hourly wage in exchange for helping out on the farm is an example of payment-in-kind.

The Internal Revenue Service (IRS) requires people who receive payment-in-kind income through bartering to report it on their income tax return. For example, if a plumber accepts a side of beef in exchange for services, they should report the fair market value of the beef or their usual fee as income on their income tax return.

The Internal Revenue Service (IRS) refers to payment-in-kind as bartering income.

Types of Payment-in-Kind

Payment-in-kind instruments have evolved to take several different forms. Today, payment-in-kind agreements may have flexible terms that depend on prevailing macroeconomic conditions or elections by the borrower. Here are the most common types of payment-in-kind agreements.

Traditional

Traditional or true payment-in-kind agreements explicitly layout the arrangement for cash payments and in-kind payments. Loan terms are predefined, and this is the most standard type of payment-in-kind arrangements. In addition to defined dollar amounts, timing expectations are also defined in advance.

Pay-If-You-Can

Pay-if-you-can agreements stipulate that interest is supposed to paid in cash at specific intervals or at a designated cadence. If the conditions surrounding interest payments are not satisfied, the borrower may opt to make a payment-in-kind interest payment. This pay-if-you-can assessment is often imposed at a higher interest rate and is only triggered if specific covenants or agreements are achieved (i.e. an insufficient amount of capital was on hand at a specific time).

Pay-If-You-Like

Sometimes called toggle notes or pay-if-you-want, pay-if-you-like agreements gives the borrower (though sometimes the issuer) the discretion to elect the type of payment to make. The borrower can often choose between paying in cash, in-kind, or a combination of the two. This structure allows a borrower to continue to pay interest on a bond or defer payments until the bond matures. Should the borrower elect to defer cash payment and instead be assessed payment-in-kind interest, the prevailing interest rate used will be higher.

Holdco Payment-In-Kind

Certain debt agreements add in a holding company ("holdco") level in which debt payment are reliant on the operating company's stream of cash. Any debt service or repayments of principal may be contingent on distributions from an operating group that may be subject to conditions of its own. Because the downstream holding company may not be guaranteed credit support from its parent entity, holdco payment-in-kind agreements are often riskier.

Payment-in-kind agreements can include shares of stock or equity discounts. Companies wanted to preserve capital can opt to dilute equity as their form of payment.

Advantages and Disadvantages of Payment-in-Kind

Advantages

Companies enter into payment-in-kind agreements because debt instruments can be used to leverage their existing capital structure. Companies looking to avoid pressuring their cash flow may engage in these agreements. This is especially true for companies with long cash conversion cycles where inventory turnover is slow and capital is often tied up for long periods of time.

Payment-in-kind agreements may also have flexibility in several respects. First, payment-in-kind agreements may give the borrower the option to may payment or in-kind payments. There may also be flexibility in terms of covenants that require one form of payment over the other.

Disadvantages

Though flexibility may be appreciated, payment-in-kind agreements may encourage a company to continually defer payments. Companies may also not be motivated to meet financial covenants as failing to achieving certain criteria may defer interest payments (which the company may find favorable).

In-kind payment assessments are often charged at a higher rate of interest than cash payments. Though a company may preserve cash, it will face higher net charges that often demand more company resources though in-kind assessments. For example, certain hybrid agreements may entitle the lender to purchase securities of the company at a discount. Again, though capital is preserve, equity is diluted and management now owns a smaller portion of the company due to the in-kind agreement.

Payment-in-Kind

Advantages
  • May allow a company to leverage their capital through debt

  • Gives a company flexibility over the method of payments

  • May help cash-strapped companies still enter into debt agreements

  • Gives a company more control over the potential timing of when payments occur

Disadvantages
  • May incentivize companies to continually defer payment obligations

  • Often result in higher interest assessments

  • May dilute ownership if interest is paid in equity or equity discounts

Example of Payment-in-Kind

To illustrate how payment-in-kind notes work, imagine a financier offers a struggling company payment-in-kind notes worth $2 million. The notes have a 10% interest rate and they mature at the end of a ten-year period. Each year, the note incurs $200,000 in interest.

However, instead of being required to repay that amount or any principal payments, the interest is added to the debt in kind, meaning more debt. As a result, by the end of the first year, the company owes $2.2 million and that amount continues to grow until the loan matures, at which time the cash is due.

What Is the Original Meaning of Payment-in-Kind (PIK)?

The phrase "payment-in-kind" also applies to accepting cash alternatives for work or services. For example, a farmhand who is given "free" room and board instead of receiving an hourly wage in exchange for helping out on the farm is an example of payment-in-kind. PIK is derived from the bartering system that was used before the advent of money as a means of exchange.

What Is Payment-in-Kind (PIK) Debt?

Payment-in-kind also refers to a financial instrument that pays interest or dividends to its investors. It's a type of mezzanine financing with characteristics indicative of debt and equities. They tend to pay a relatively high rate of interest but are considered risky. PIK notes give the issuer a chance to delay making dividend payments in cash and return for the delay, the issuing company typically agrees to offer a higher rate of return on the note.

Why Would PIK Debt Be Attractive to Some Firms?

PIK securities are attractive to companies preferring not to make cash outlays. In most cases, PIK notes compromise a fraction of a company's total outstanding debts, and the financier structures these notes so they mature later than the company's other debts. This allows the company to focus on repaying traditional debts or debts tied to cash dividends more quickly, PIK debt is often used in leveraged buyouts.

How Is Payment-in-Kind Taxed?

The Internal Revenue Service considers bartered exchanges as income. The fair market value of goods and services are often taxable, as the recipient received a value even though the exchange was not made in cash.

The Bottom Line

Some payment-in-kind arrangements call for periodic assessments of interest. Interest on these debt instruments may be made in cash, or a company may be assessed additional debt, equity, or other non-cash charges. Though payment-in-kind agreements favor a company not wanting to part with cash, the company often faces a steeper interest expense through a higher interest rate when opting for the in-kind payment option.

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  1. Internal Revenue Service. "Topic No. 420, Bartering Income."