An equity kicker is an equity incentive where the lender provides credit at a lower interest rate and, in exchange, gets an equity position in the borrower’s company. An equity kicker is structured as a conditional reward, where the lender gets equity ownership that will be paid at a future date when the business attains specific performance goals.
Early-stage companies use an equity kicker to access funds to finance their operations. They often find it difficult to attract investors since they are relatively new and less likely to earn investors’ trust.
Equity kickers are typically used with LBOs, MBOs, and equity recapitalizations. Such transactions are considered too risky to attract traditional forms of debt. Therefore, mezzanine and subordinated lenders use equity kickers to compensate them for the increased risk of lending to companies with insufficient collateral for loans. The kickers use a convertible feature for shares or warrants at a future date and can be triggered by a sale or other liquidity events.
How Does an Equity Kicker Work?
Companies use an equity kicker to entice lenders to purchase a bond or preferred share from the company at a reduced interest rate. The lender may get an equity kicker from as low as 10% to as high as 80%, depending on how risky the portfolio is.
When a borrower attaches an equity incentive to the terms of debt advanced by lenders, the incentive is referred to as a kicker. Even though the lenders lend at a low interest rate as part of the deal, they get equity ownership that can be exercised at a future date when a liquidity event occurs.
Uses of Equity Kicker
Companies that offer an equity kicker embedded option are mostly unable to access credit from traditional lenders. Lenders typically lend to companies with adequate cash flows to service the loan, as well as enough of an asset base to act as security for the loan.
Most companies that issue equity kickers are startups and early-stage companies that are yet to accumulate enough assets. They offer a kicker as a way of attracting investors who would otherwise be uninterested in lending to the company.
Example 1: Equity ownership
Let’s take the example of XYZ, a startup company that manufactures wine glasses. The company is in the process of expanding its manufacturing plant to increase annual production. XYZ has been operating for three years but remains unable to secure financing from senior secured lenders due to its perceived high risk.
The company plans to raise $800,000 to finance the expansion. It can raise $400,000 internally from its retained earnings. The company plans to give up 10% equity for every $100,000 loaned by investors.
Three investors – A, B, and C – then come on board to finance XYZ’s expansion. Investor A is willing to provide $200,000, while B and C are ready to contribute $100,000 each. This means that investor A gets an equity kicker of 20%, while B and C get 10% each. However, the investors can only exercise the right to obtain stocks during a sale of the company.
Example 2: Warrants
Assume that the debt is structured as a warrant, where the lenders are given the option to buy a certain amount of stocks at a particular price at a future date. For example, the borrower can give a 10% warrant coverage on the amount provided by each lender to the company.
Using the figures in Example 1, we can deduce that investor A will get $20,000 in warrants, while B and C will get $10,000 each worth of warrants for the company’s stock. The stock’s pricing will depend on the most recent capital roundup.
Lenders Options of the Equity Kicker
Lenders provide financing to a company to help them achieve specific performance targets and increase the value of the company above its current fair market value. In exchange, the lenders get equity ownership that can only be paid if a breakpoint is achieved or a liquidity event occurs. Without any of these events happening, the lenders will continue holding their equity position.
As equity holders, they benefit from regular dividend payouts when the firm’s financial results are published, as well as a percentage of earnings that is proportionate to their equity ownership percentage. In the event that the company attains a certain pre-agreed earnings potential or when the owners decide to dispose of the company, the lenders are paid first when such events occur.
Equity Kicker in Real Estate
An equity kicker is also used in the real estate industry. A lender may provide a real estate loan at a reduced interest rate in exchange for a share in the total income from the property. The kicker may be provided when the borrower lacks enough collateral to provide security for the loan but is expected to be able to pay off the loan with future earnings potential if it gets funds to finance its operations or expansion.
The equity kicker may be structured in such a way that the lender receives a percentage of the gross rental income generated by the property if it exceeds a certain pre-agreed amount. It may also be dependent on a future event such as the sale of the property, where the lender will get a percentage of the sale proceeds dependent on the amount of their equity in the company.
For example, let’s assume that a borrower borrowed $1 million for the purchase of a luxury condo. The borrower uses the loan to complete the purchase and renovate the condo for lease. Immediately after the renovations, the value of the condo doubles to $2 million, due to increasing demand for luxury condos. If the borrower initially provided an equity kicker of 10% to sweeten the deal, it means that the lender will get a 10% share of the value gained by the property once it is sold.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful:
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