Unlocking Hidden Value: How Equity Kickers Can Sweeten Your Deal

What is an Equity Kicker?

An equity kicker is like a bonus in commercial finance deals. It rewards lenders based on the borrower's company success and allows lenders to receive equity or equity-related benefits in the future under certain conditions, encouraging them to provide financing with favorable terms.

This arrangement involves non-standard rates from lenders and allows them to acquire equity ownership or equity-related benefits if specific milestones or events occur.

Equity kickers are commonly used in commercial real estate, venture capital, and private equity, compensating lenders for higher-risk investments. They enable borrowers to secure funding without sacrificing ownership or paying high interest rates while offering lenders the opportunity to share in the profits of a successful deal.

How Do Equity Kickers Work?

Equity kickers represent an agreement in which lenders are entitled to advantages like ownership stakes or comparable perks in return for providing advantageous loan terms. This setup links the lender's motivations to the prosperity of the borrower's enterprise or the real estate asset being funded. The lender gains access to the benefit upon achievement of designated objectives or performance criteria by a set deadline.

For instance, a lender might offer a startup a reduced interest rate in return for set-price shares if the business reaches a revenue goal within a specified period. In real estate, a lender could agree to lower interest repayments in exchange for a portion of the total rental income if occupancy levels exceed a specific limit over time. This equity kicker allows the investor or lender to share in gains.

Meeting the benchmarks allows the lender to benefit from value growth, providing added incentive to offer or access credit on favorable terms to high-potential but risky borrowers. For borrowers, equity kickers enable access to credit or improved financing terms while sharing in the project's future success. Both parties can benefit from the equity kicker structure if the business proliferates or the assets appreciate significantly.

Types of Equity Kickers

An equity kicker gives the lender some contingent equity participation in the borrower's business or financial instruments. There are several common structures used for equity kickers:

Warrants

A warrant has an exercise period of 3 to 10 years, giving the lender the right to purchase shares of the borrower company's stock at a preset price. This allows the lender to benefit from future company share price growth.

For example, a lender may offer a loan with a reduced interest rate in exchange for warrants to purchase 10,000 shares at $1 per share within 5 years. If the company succeeds, the shares will likely be worth more than $1 in 5 years.

Convertible Debt

Convertible debt is a particular type of loan that allows a lender to convert a loan into equity shares under specified circumstances. This conversion from debt to equity is "triggered" by certain events like a future funding round or IPO. Convertible debt allows the lender to exchange the principal for shares, often at a discounted conversion price. This gives them an equity upside if the company grows substantially.

Profit Participation

In a profit participation agreement, one is entitled to a percentage of future profits or revenue. This may involve a percentage of net income, gross profits, or free cash flow. Profit participation rewards the lender when the business succeeds. However, they also share the risk of lower profits if the business underperforms.

Carried Interest

Carried interest provides the lender a share of profits once earnings exceed a threshold hurdle rate. For example, the lender may get 20% of profits above a 15% internal rate of return. This incentivizes the lender to help grow the profits. Their carried interest will be higher if the company achieves an exceptional return on investment.

Benefits of Equity Kickers

Equity kickers can benefit lenders and borrowers when used in financing agreements.

Higher Potential Returns for Lenders

One significant advantage of having an equity kicker for lenders is the chance to earn returns on their investments compared with debt financing. When the borrower's business does well, an equity kicker enables the lender to make profits. This provides them with more than just their principal plus interest payments. The equity upside acts as an additional incentive to for lenders to provide financing.

For example, a lender receiving warrants for equity shares as part of an equity kicker deal can profit considerably if the borrower's company has an exit or gets acquired at a high valuation. The lender can capture some of that value creation through their equity position. This potential for more significant returns makes deals more attractive for lenders.

Attracts Lenders

Equity kickers are valuable as they can increase profits, making them a key factor in enticing lenders to offer support. Equity kickers encourage lenders to support high-growth businesses despite the risks involved by providing an equity incentive back. This strategy appeals to traditional lenders, who are typically cautious when investing in early-stage companies. However, the prospect of equity-based returns allows lenders to offset risk. This makes them more willing to provide capital to younger companies, expanding their financing options.

Lower Interest Rates for Borrowers

Equity kickers also benefit borrowers by allowing them to access lower-interest-rate debt. Since lenders receive potential equity upside, they may accept lower interest rate payments on the debt portion of the financing. This mutually beneficial arrangement results in cheaper access to capital for the borrower. Rather than paying high-interest rates, the borrower provides an equity upside opportunity. This can significantly lower the company's financing costs.

Risks of Equity Kickers

Equity kickers can pose risks that borrowers should consider carefully before agreeing. The main risks include the following:

• Lower returns if performance targets are unmet - With equity kickers, the lender shares in the upside if goals are exceeded. However, on the other hand, they might experience reduced profits in case the company does not perform well and fails to achieve its goals. For instance, if a real estate asset does not produce the anticipated earnings or revenue from a transaction, the lender's overall profit will be less than a loan's.
• Dilution of ownership for borrowers - By granting equity or future equity stakes to lenders, the borrower's ownership position becomes diluted. This means they will own a smaller percentage of the business if the lender eventually obtains shares. The dilution can be significant if the equity stake is large.
• Complex legal agreements required - Properly structuring equity kickers requires detailed legal documents and agreements between the borrower and lenders. These agreements ensure all parties understand the conditions, dilution implications, and other complexities. Negotiating these agreements adds complications, legal costs, and paperwork burdens.

Equity kickers can provide lenders with a nice upside. Still, borrowers need to carefully weigh whether the risks of lower returns, ownership dilution, and legal complexities are worth the potential benefits of attracting financing and improving loan terms. Alternatives like preferred equity and joint ventures may offer simpler structures.

Equity Kickers for Startups

Equity kickers are frequently utilized in startup funding to entice venture capital investors. Due to startups' lack of assets or consistent revenue streams, equity kickers offer investors added motivation by enabling them to secure equity shares if the company achieves specific performance goals.

An instance of an equity kicker employed by startups is a convertible note. This functions as a loan that transforms into ownership shares upon meeting criteria. For example, the convertible note might change into equity shares at a reduced price when the startup secures a funding round. Alternatively, it could convert if the company attains a valuation through an acquisition or initial public offering.

Adding a conversion feature makes the convertible note more appealing to investors, as they gain the potential for shared upside if the startup succeeds. At the same time, it reduces the interest rate on the startup's debt. In the phases of their journey, startups utilize equity kickers to obtain funding and offer investors rewards for backing ventures in uncertain enterprises. As entrepreneurs seek out the backing, equity kickers have become a strategy to encourage investors and foster partnerships between startup founders, investors, and venture capitalists.

Negotiating Equity Kickers

When structuring an equity kicker, the lender and borrower must negotiate fair terms. Here are some tips:

• Set clear performance targets. The equity kicker should be tied to concrete goals like a sale, IPO, or reaching a certain revenue threshold. Make sure the goals are realistic yet require the borrower to grow substantially.
• Get professional valuations. Hire an independent valuator to determine the fair value of the kicker based on the expected growth trajectory. This prevents disputes down the line.
• Balance risk and reward. Lenders need sufficient upside to compensate for the increased risk. However, borrowers should limit potential dilution and loss of control.
• Consider vesting schedules. Tying the equity to incremental vesting reduces risk for the lender. For example, 10% vested each year for 10 years.
• Structure multiple exit options. Provide flexibility to execute the kicker as a share conversion, sale of the loan, or even a one-time cash payout.
• Allow sufficient time to execute. Give the borrower  5-10 years to hit the targets before the lender can exercise the equity kicker.
• Get a legal review. Equity kickers require careful negotiation and structuring, so it is essential to get experienced lawyers to protect both parties. Setting realistic targets, limiting dilution, allowing flexibility, and getting a legal review enables lenders and borrowers to benefit from the added upside.

Valuing Equity Kickers

Equity kickers can be challenging to value accurately since their worth depends on unknown future events. However, there are several factors to consider when estimating the potential value of an equity kicker:

• Performance projections - What are the expected financial projections and metrics, like revenue, profit, sales growth, etc., that will determine the value of the equity? More optimistic forecasts generally mean higher valuation.
• Likelihood of liquidity events - The equity usually can't be readily sold, so a liquidity event like an IPO or acquisition is often needed to realize its value. The timing and probability of such an event affect value.
• Company valuation - Projecting the company’s future valuation based on market comps and multiples is key. A higher overall company valuation means the equity kicker will be worth more.
• Size of equity stake - The percentage of equity offered as a kicker determines value. More equity translates to higher potential value.
• Duration - Equity kickers can last for 5-10 years. Longer duration increases the range of outcomes and uncertainty. Financial models can be built using the above factors as inputs to calculate a potential valuation range for the equity kicker. Value can be estimated assuming different exit scenarios and timing. Using a discounted cash flow analysis helps account for the time value of money. The probability of the scenarios occurring should discount the end valuation. Expert advice can often properly assess the value.

Alternatives to Equity Kickers

While equity kickers can provide upside potential, they also come with risks like dilution of ownership. In some cases, there may be better alternatives to equity kickers to consider:

Traditional Financing

The most basic alternative is conventional financing without any equity components. This avoids any potential ownership dilution for the borrower. However, traditional financing through debt securities typically comes at higher interest rates and fees than equity kickers deal.

Preferred Equity

In this case, a lender is entitled to a fixed preferred return on their investment and gets priority over common equity holders. This provides more secure returns for lenders while avoiding dilution for borrowers. However, the tradeoff is borrowers lose the upside potential of equity kickers.

Joint Ventures

Another option is entering a joint venture, where the lender becomes an equity partner immediately. This aligns incentives and shares risk from the beginning. However, the lender will require higher equity stakes and returns than a debt-based equity kicker.

Evaluating alternatives requires weighing the benefits of equity kickers against the risks. There are tradeoffs for both borrowers and lenders. Understanding these options allows for the best terms for a particular deal to be negotiated.

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