Embedded derivatives Equity kicker – A more specific type of embedded derivative that is often found in practice relates to a type of funding provided by venture capital entities is the equity kicker. It is many times part of a sales of a part of a business of a listed company, financed by the venture capital entity. The intention is to prepare the separated business for an IPO within 3 – 5 years after this separation. Embedded derivatives Equity kicker
Example Mezzanine financing Equity kicker
A venture capitalist provides a subordinated loan, that in addition to interest and repayment of principal, contains terms that entitle the venture capitalist to receive shares of the borrower (separated business) free of charge or at a very low price (an ‘Equity kicker’) if the borrower undergoes an IPO. As a result of this feature, the interest on the subordinated loan is lower than it would otherwise be. Embedded derivatives Equity kicker
The ‘equity kicker’ meets the definition of a derivative even though the right to receive shares is contingent upon the future listing of the borrower. IFRS9 BA.1 states that a derivative could require a payment as a result of some future event that is unrelated to a notional amount.
An ‘equity kicker’ feature is similar to such a derivative except that it does not give a right to a fixed payment, but an option right if the future event occurs. As the economic characteristic and risks of an equity return are not closely related to the economic characteristic and risks of a host debt instrument, the embedded derivative would be accounted for separately by the venture capitalist. [IFRS 9IG C.4] Embedded derivatives Equity kicker
Mezzanine financing bridges the gap between debt and equity financing and is one of the highest-risk forms of debt. It is subordinate to pure equity but senior to pure debt.
However, this means that it also offers some of the highest returns when compared to other debt types, as it often receives rates between 12% and 20% per year. Embedded derivatives Equity kicker
Companies commonly seek mezzanine financing to support specific growth projects or acquisitions. The benefits for a company in obtaining mezzanine financing include the fact that the providers of mezzanine capital are often long-term investors in the company.
This makes it easier to obtain other types of financing since traditional creditors generally view a company with long-term investors in a more favorable light and are therefore more likely to extend credit and favorable terms to that company.
- In relation to the priority with which they are paid, these loans are subordinate to senior debt but senior to common equity.
- Differing from standard bank loans, mezzanine loans demand a higher yield than senior debt and are often unsecured.
- No principal amortization exists. Embedded derivatives Equity kicker
- Part of the return on a mezzanine loan is fixed, which makes this type of security less dilutive than common equity. Embedded derivatives Equity kicker
- Subordinated debt is made up of a current interest coupon, payment in kind and warrants. Embedded derivatives Equity kicker
- Preferred equity is junior to subordinated debt, causing it to be viewed as equity coming from more senior members in the structure of the capital financing.
Embedded derivatives Equity kicker
Companies commonly seek mezzanine financing to support specific growth projects or acquisitions. The benefits for a company in obtaining mezzanine financing include the fact that the providers of mezzanine capital are often long-term investors in the company. Embedded derivatives Equity kicker Embedded derivatives Equity kicker
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