Equity Kicker

An ownership that adds value to debt

An equity kicker is an ownership that adds value to debt. It occurs when a lender offers a loan at a lower interest rate and, in exchange, receives an equity position in the borrower's company. As a result, the lender's conditional right is added to a debt instrument. 

Equity Kicker

The kicker (the incentive) makes a loan more desirable, as it gives the lender the option to purchase shares of the borrower. A kicker is established by assuming that the borrowing company will accomplish specific performance goals. 

The lender will receive its equity payment once the borrowing company attains the prescribed goals. 

Most often, these are used by early-stage startups seeking ways to finance their operations. Startups typically need a special way to attract investors because they may not have easily-projectable cash flows that are required for investors to value the company.

An early-stage company needs other ways to obtain the trust of investors so that it may offer lenders equity in their company in exchange for a loan.  

It is usually used in management buyouts (MBOs), leveraged buyouts (LBOs), and equity recapitalizations. 

  • Management buyout: An MBO occurs when a management team purchases a total or majority stake of the company it manages.  
  • Leveraged buyout: An LBO occurs when one company acquires another using a large amount of debt (i.e., bonds or loans). 
  • Equity recapitalization: Equity recapitalization occurs when a company restructures its debt-to-equity ratio. The recapitalization process aims to stabilize a company's capital structure

These three types of transactions are typically deemed too risky to utilize traditional debt, so that is why kickers are useful. In addition, mezzanine and subordinated lenders use kickers to compensate for the increased risk of lending to certain companies. 

  • Subordinated debt: an unsecured debt, meaning in the event of default, lenders who only own subordinated debt will not be repaid until secured creditors are fully paid. 
  • Mezzanine debt: a form of hybrid debt that contains embedded equity (warrants). These warrants increase the value of subordinated debt. Mezzanine debt is subordinated to senior debt but is to be repaid before payments are made to equity holders. 

MBOs, LBOs, and equity recapitalizations use convertible features for either shares or warrants at a date in the future. These can be activated by either a sale or another liquidity event. Examples of liquidity events include initial public offerings (IPOs) and mergers and acquisitions (M&A). 

How does an equity kicker work?

A company uses an equity kicker to attract lenders to buy a bond or preferred stock from the company at a lower interest rate. The interest rate can range from around 10% to 80%, with the rate depending on the company's risk. 

How Does It Work

A kicker arises when a borrower adds an equity incentive to the debt advanced by lenders. The equity ownership that is part of the deal can be utilized when a liquidity event occurs in the future.

The goal of a kicker is to solidify a deal that may not otherwise be realized without offering additional benefits to the lender. A kicker is expected to increase the lender's return on investment (ROI). 

Investors typically look for companies with a solid financial record of steady sales growth and profits.

However, an early-stage startup may not have these records and may need money to finance its early-stage business operations. So, many young startups offer a kicker of equity as an additional incentive for investors to purchase their debt securities. 

NOTE

An equity kicker is sometimes referred to as an equity sweetener. The two terms have the same meaning. 

Uses

As discussed above, companies that typically issue equity kickers are early-stage startups. These companies are usually unable to obtain credit from traditional lenders, so they offer an additional incentive (the kicker).

Uses

Young companies almost always have inadequate assets, cash flow, and collateral to back traditional loans. So instead, the money these companies raise through debt and equity kickers can be used for startup funding. 

  • Startup funding is the money used by entrepreneurs to finance the launch of their businesses. For example, the funding may be used to hire staff, rent or purchase space, buy inventory, etc. 

These are often used in mezzanine financing transactions. As briefly mentioned before, mezzanine debt is a hybrid of traditional debt and equity. In mezzanine financing, the lender possesses the right to convert the debt into an equity interest in the case of default. 

Mezzanine lenders are paid after venture capital companies and other more senior lenders. The riskiness of this type of investment is in between senior debt and equity. Mezzanine finance is often used for buyouts and acquisitions to prioritize new owners over existing owners. 

We will discuss later that these are also often used in real estate. However, using kickers in real estate is illegal in some areas, so lenders must be careful. 

Types

Types

There are different types, such as:

1. Convertible feature

A convertible feature is a bond, preferred share, or other financial instruments that can be converted into stock by the holder. These types of securities are classified as a hybrid of debt and equity.

A convertible feature placed on bonds allows the bonds to be exchanged for shares.

2. Warrants 

A warrant gives lenders security that grants them the right to purchase a company's stock at a fixed price and until a set date. 

The specified price that lenders can be stock for is called the strike price. A warrant is "in-the-money" if the strike price is less than the stock's price or value. 

Because warrants grant more ownership participation in a company, it is dilutive. More ownership participation means that more shareholders must share earnings. 

3. Real estate kickers

In real estate, a kicker is an additional expense on a mortgage that must be paid to approve a loan. A kicker can grant a lender a share of a property's income or gross rental receipts. 

Frequently, a real estate equity warrant grants a lender equity in a real estate project. 

How to calculate

Calculate

Calculating convertible preferred stock 

Company X wants to raise $500,000 to finance an expansion. In addition, it can raise $200,000 internally from its retained earnings. Company X plans to give up 5% equity for every $100,000 loaned by investors. 

Three investors, A, B, and C, want to help finance Company X's expansion. A will invest $50,000, while B and X will contribute $125,000 each. This means A will receive an equity kicker of 2.5%, while B and C will each get 6.25%. 

Only during a sale of Company X can the three investors exercise their rights to obtain stocks. 

Calculating equity warrants:

Company X gives 3% equity for every $5 million of loans granted by the investors. Three investors (A, B, and C) want to invest in Company X. Investor A will invest $10 million, while B and C will invest $15 each. 

Therefore, A will get equity warrants equivalent to 6%. B and C will get warrants equivalent to 9%.

Calculating real estate equity kicker:

In real estate, the equity kicker is a share of ownership of a property's gross revenue or rental income. It can be calculated using the following equation:

Equity Kicker = X% of gross revenues/rental income

Example: If a 5-year loan has an equity kicker of 15% of rental income, and that income is $2 million per year, then the equity kicker is worth $300,000 per year for the life of the loan. 

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Researched and authored by Rachel Kim | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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