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.
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 in return for the delay, the issuing company typically agrees to offer a higher rate of return on the note.
Example of How PIK Notes Work
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.
Payment-in-Kind Versus Trade and Barter
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.
[Important: The Internal Revenue Service (IRS) refers to payment-in-kind as bartering income.]
The 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, he should report the fair market value of the beef or his usual fee as income on his income tax return.
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.
- Payment-in-kind (PIK) is the use of a good or service as payment instead of cash.
- The phrase "payment-in-kind" also applies to accepting 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.