# Payment-in-Kind (PIK): Definition, Operation, Advantages, and Risks

> **Definition**
>
> Payment-in-kind (PIK) is the use of a good or service as payment instead of cash. It also refers to certain financial instruments.

## What Is Payment-in-Kind (PIK)?

Payment-in-kind (PIK) is noncash compensation, using goods or services, 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](https://www.investopedia.com/terms/s/security.asp) or [equity](https://www.investopedia.com/terms/e/equity.asp) instead of cash.

Payment-in-kind is attractive to companies preferring not to make immediate cash payouts. It is often used in leveraged [buyouts](https://www.investopedia.com/terms/b/buyout.asp).

However, PIK also comes with risks involved, such as possible higher interest rates and dilution of shareholder equity.

### Key Takeaways

*   Payment-in-kind (PIK) allows companies to make payments using goods, services, or additional securities instead of cash, which can help preserve cash flow, particularly during financial constraints.
*   PIK securities are often used in high-risk financial strategies like leveraged buyouts and mezzanine financing, offering higher interest rates due to their deferred cash payments.
*   Companies may choose from various PIK structures such as traditional, pay-if-you-can, pay-if-you-like, and holdco, each with its unique flexibility and risk considerations.
*   While PIK agreements provide flexibility, they often come with higher interest rates, which could lead to increased debt or diluted equity, potentially impacting a company's financial stability in the long term.
*   The IRS considers PIK income as taxable, similar to bartering income, necessitating reporting the fair market value of the noncash payment on income tax returns.

![Payment-in-Kind (PIK): Using a good or service as payment instead of cash.](https://www.investopedia.com/thmb/20oI7RHEv1s-3VY673qEAmwgXrY=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/paymentinkind.asp-Final-9cd61c4af5c44ac09223dffd0ba0624f.png)

*— Investopedia / Dennis Madamba*

## Comprehensive Guide to Payment-in-Kind (PIK)

Payment-in-kind securities are a type of [mezzanine financing](https://www.investopedia.com/terms/m/mezzaninefinancing.asp), 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](https://www.investopedia.com/terms/p/privateequity.asp) investors and [hedge fund](https://www.investopedia.com/terms/h/hedgefund.asp) 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.

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.

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.

The Internal Revenue Service (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, they should report the fair market value of the beef or their usual fee as income on their income tax return.  

> **Important**
>
> The IRS refers to payment-in-kind as bartering income.

## Exploring Different Types of Payment-in-Kind

Payment-in-kind instruments have evolved to take several different forms. Agreements may have flexible terms that depend on prevailing [macroeconomic](https://www.investopedia.com/terms/m/macroeconomics.asp) conditions or elections by the borrower.

### Traditional

Traditional or true payment-in-kind agreements explicitly lay out the arrangement for cash payments and in-kind payments. [Loan terms](https://www.investopedia.com/loan-terms-5075341) are predefined, and this is the most standard type of payment-in-kind arrangements. In addition to defined dollar amounts, timing expectations are also defined in advance.

### Pay-If-You-Can

Pay-if-you-can agreements stipulate that interest is supposed to paid in cash at specific intervals or at a designated cadence. If the conditions surrounding interest payments are not satisfied, the borrower may opt to make a payment-in-kind interest payment. This pay-if-you-can assessment is often imposed at a higher interest rate and is only triggered if specific covenants or agreements are achieved (i.e., an insufficient amount of capital was on hand at a specific time).

### Pay-If-You-Like

Sometimes called toggle notes or pay-if-you-want, pay-if-you-like agreements gives the borrower (though sometimes the issuer) the discretion to elect the type of payment to make. The borrower can often choose between paying in cash, in-kind, or a combination of the two. This structure allows a borrower to continue to pay interest on a bond or defer payments until the [bond matures](https://www.investopedia.com/terms/m/maturitydate.asp). Should the borrower elect to defer cash payment and instead be assessed payment-in-kind interest, the prevailing interest rate used will be higher.

### Holdco Payment-in-Kind

Certain debt agreements add in a [holding company](https://www.investopedia.com/terms/h/holdingcompany.asp) ("holdco") level in which debt payments are reliant on the operating company's stream of cash. Any debt service or repayments of principal may be contingent on distributions from an operating group that may be subject to conditions of its own. Because the downstream holding company may not be guaranteed credit support from its parent entity, holdco payment-in-kind agreements are often riskier.

> **Fast Fact**
>
> Payment-in-kind agreements can include shares of stock or equity discounts. Companies wanting to preserve capital can opt to dilute equity as their form of payment.

## Pros and Cons of Payment-in-Kind

### Advantages

Companies use payment-in-kind agreements to leverage their existing capital structure through debt instruments. Companies looking to avoid pressuring their cash flow may engage in these agreements. This is especially true for companies with long [cash conversion cycles](https://www.investopedia.com/terms/c/cashconversioncycle.asp) where inventory turnover is slow and capital is often tied up for long periods of time.

Payment-in-kind agreements may also have flexibility in several respects. First, payment-in-kind agreements may give the borrower the option to make payment or in-kind payments. There may also be flexibility in terms of covenants that require one form of payment over the other.

### Disadvantages

Though flexibility may be appreciated, payment-in-kind agreements may encourage a company to continually defer payments. Companies may also not be motivated to meet financial covenants as failing to achieve certain criteria may defer interest payments (which the company may find favorable).

In-kind payments usually come with higher interest rates than cash payments. While preserving cash, a company will face higher charges that require more resources due to in-kind assessments. For instance, some hybrid agreements let lenders buy company securities at a discount. Although capital is saved, equity is [diluted](https://www.investopedia.com/terms/d/dilution.asp), leading to management owning less of the company.

Advantages

*   May allow a company to leverage their capital through debt
    
*   Gives a company flexibility over the method of payments
    
*   May help cash-strapped companies still enter into debt agreements
    
*   Gives a company more control over the potential timing of when payments occur
    

Disadvantages

*   May incentivize companies to continually defer payment obligations
    
*   Often result in higher interest assessments
    
*   May dilute ownership if interest is paid in equity or equity discounts
    

## Understanding In-Kind Donations

Both in-kind donations and payments-in-kind involve exchanging goods or services instead of money. Payments-in-kind usually describe business transactions, while in-kind donations refer to nonprofit activities.

An example of an in-kind donation for a nonprofit auction would be a local caterer donating food services for a private event. Instead of contributing cash, the caterer offers a complete catering package, including food, setup, and service for a dinner party or special occasion. As opposed to a payment-in-kind, the caterer is not expected any reciprocal payment (aside from potentially a [tax deduction](https://www.investopedia.com/tax-deductions-6834385)).  

The similarities between in-kind donations and payment-in-kind extend to how they are treated for accounting and tax purposes. In both cases, the receiving party must account for the value of the noncash goods or services received, and this value is typically included as part of their financial reporting. For tax purposes, donors of in-kind donations can often claim a deduction.

## Navigating Payment-in-Kind Bonds

Payment-in-kind bonds let issuers pay interest by issuing more bonds instead of using cash. This allows companies to defer cash interest payments until the bond matures, reducing immediate cash outflows and providing flexibility in managing their cash.

Issuing PIK bonds causes a company to incur more debt to create new bonds for interest payments. On scheduled [coupon payment](https://www.investopedia.com/terms/c/couponbond.asp) dates, instead of distributing cash, the issuer provides bondholders with additional securities, typically similar to the underlying bonds but occasionally with different terms. This process continues throughout the initial period of the bond's life, allowing the issuer to preserve cash for other purposes or investments.

The structure of PIK bonds can vary, with some offering a "toggle" feature that allows the issuer to choose between making cash interest payments or issuing additional bonds. PIK bonds generally offer higher yields than traditional bonds due to the increased risk associated with deferred cash payments.

## Practical Example of Payment-in-Kind

To illustrate how payment-in-kind notes work, imagine a financier offering a struggling company payment-in-kind notes worth $2 million. The notes have a 10% interest rate and mature at the end of a 10-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 when the cash is due.

## What Is the Original Meaning of Payment-in-Kind (PIK)?

The phrase "payment-in-kind" also applies to [accepting cash alternatives](https://www.investopedia.com/terms/n/nonmonetary-transaction.asp) 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. PIK is derived from the bartering system that was used before the advent of money as a means of exchange.

## What Is Payment-in-Kind Debt?

Payment-in-kind also refers to a financial instrument that pays interest or dividends to its investors. It's a type of mezzanine financing with characteristics indicative of debt and equities. They tend to pay a relatively high rate of interest but are considered risky. PIK 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.

## Why Would PIK Debt Be Attractive to Some Firms?

PIK securities are attractive to companies preferring not to make cash outlays. 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, PIK debt is often used in leveraged buyouts.

## How Is Payment-in-Kind Taxed?

The Internal Revenue Service considers bartered exchanges as income. The fair market value of goods and services are often taxable, as the recipient received a value even though the exchange was not made in cash.

## The Bottom Line

Payment-in-kind (PIK) is the use of a good or service as payment or compensation instead of cash. It also refers to debt instruments that call for interest payments that may be paid in cash or noncash assessments.

Payment-in-kind can help companies preserve their cash flow, offering flexibility if they have specific financial constraints or long cash conversion cycles.

Different PIK structures include:

*   Traditional, which lays out the arrangement for cash payments, in-kind payments, and timing expectations
*   Pay-if-you-can, which stipulates interest payments in cash at specific intervals or a designated cadence
*   Pay-if-you-like, which lets the borrower (or sometimes the issuer) pick the payment type
*   Holdco, which adds a holding company level in which debt payments rely on the operating company's cash stream

The risks associated with payment-in-kind are that the company often faces higher interest rates that may be added to its principal balance, increased debt, or dilution of its shareholder equity.

The IRS views payment-in-kind as bartering income, and it requires people who receive such income to report it on their income tax returns.

PIK might be suitable for companies willing to accept increased risk in exchange for greater cash flow management flexibility.

> **Article Sources**
>
> 1.  Internal Revenue Service. "[Topic No. 420, Bartering Income](https://www.irs.gov/taxtopics/tc420)."
>     
> 2.  Internal Revenue Service. "[Charitable Contributions: Written Acknowledgements](https://www.irs.gov/charities-non-profits/charitable-organizations/charitable-contributions-written-acknowledgments)."