- What is a Shareholder Loan?
- How Does a Shareholder Loan Work?
- What is the PIK Interest Rate on Shareholder Loans?
- How to Calculate Shareholder Loan Value
- Shareholder Loan Value Formula
- Shareholder Loan Calculator
- 1. Private Equity LBO Transaction Financing Assumptions
- 2. PIK Interest Calculation Example
- 3. Shareholder Loan Calculation Example
What is a Shareholder Loan?
A Shareholder Loan is a form of specialized financing with features that blend debt and equity, most often structured with a PIK interest component.
How Does a Shareholder Loan Work?
Often referred to as preferred stock, a shareholder loan sits between debt and common equity in the capital structure.
Usually, the term “shareholder loan” is only used when discussing a private company rather than a publicly traded company.
For example, a financial sponsor or a specialty lender could provide financing to a company, and the investment would be called a shareholder loan.
Considering the placement of the claims held by preferred equity holders in a company’s capital structure, the investment carries less risk than common equity in the event of default (and thus, the preferred equity investor would expect lower returns in comparison).
But while preferred equity holders are prioritized over common equity, shareholder loans still rank lower in priority than other more senior forms of debt and are thereby more vulnerable if a company is at risk of financial distress.
In the event of default by the underlying company either in a reorganization or liquidation, there is the risk that the preferred equity investors might not receive any recovery, especially if there is a significant amount of outstanding debt on the company’s balance sheet.
What is the PIK Interest Rate on Shareholder Loans?
Most shareholder loans are structured with a fixed paid-in-kind (PIK) interest rate.
The term PIK stands for “paid-in-kind” and describes interest payments that are recognized, however, the investor does not receive the payment in cash yet.
The non-cash interest instead accrues towards the ending principal of the loan, as opposed to being paid in the current period by the company.
While PIK interest technically might be more beneficial to the company than traditional cash interest from a near-term perspective, the accrued interest compounds each period.
Thus, the original principal upon which the owed interest payments are determined continues to expand, which increases the accrued interest over time, i.e. “interest on interest”.
In effect, the compounding effects of the PIK interest component becomes gradually more pronounced over prolonged durations.
For that reason, the negotiated PIK rate tends to decline in tandem with the investment term.
The lender, assuming the company does not default, is guaranteed a specific rate of return on the shareholder loan (and other clauses could be attached to further increase returns, such as a conversion feature on the date of exit).
How to Calculate Shareholder Loan Value
Below are the 3 steps to calculate the value of a shareholder loan:
- Step 1 → Find the Original Capital Investment Amount (t = 0)
- Step 2 → Raise the Sum of 1 and the PIK Interest Rate to the Power of the Number of Periods (n)
- Step 3 → Multiply the Original Capital Investment by the Resulting Figure from Step 2
Shareholder Loan Value Formula
The formula for the shareholder loan value is as follows:
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We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Private Equity LBO Transaction Financing Assumptions
Suppose a specialty lender has decided to participate in the financing of a leveraged buyout (LBO) transaction.
The cost of purchasing the company is $265 million, with the only other usage of cash consisting of $20 million in fees, such as M&A advisory fees and financing fees.
- Purchase Price = $265 million
- Fees = $20 million
Therefore, the “Total Uses” to complete the buyout is $285 million.
The financing for the LBO is contributed by three sources (ranked in order of highest seniority to lowest):
- Term Loan B
- Shareholder Loan (PIK Notes)
- Common Equity
The financial sponsor, i.e. the private equity firm, was able to raise $140 million in the term loan B tranche and $60 million from the specialty lender, with the remaining amount provided by the sponsor in the form of common equity.
- Term Loan B = $140 million
- Shareholder Loan = $60 million
- Common Equity = $85 million
2. PIK Interest Calculation Example
Over the holding period, which we’ll assume is 5 years, the principal of the shareholder loan will grow at a rate of 8.0%.
- Holding Period (n) = 5 Years
- PIK Rate = 8.0%
From Year 1 to Year 5, we’ll multiply the beginning balance in each period by the PIK rate to determine the accrued interest expense.
3. Shareholder Loan Calculation Example
The accrued interest expense, as mentioned earlier, is not paid in cash but instead added to the ending balance, which in turn becomes the beginning balance in the next year.
- Shareholder Loan, Ending Balance = Beginning Balance + PIK Interest
The principal of the shareholder loan was initially $60 million, but the accumulated PIK interest causes it to grow to $88 million by the end of Year 5, with the annual PIK interest also increasing from approximately $5 million to $7 million across the same time frame.
