Interest rate

The interest rate is the headline number in any venture loan. If the return from warrants is modest or zero the majority of a lender’s return will come from the interest rate. For that reason it is a main point of negotiation.

In a standard deal the rate is shown as a fixed annual percentage, paid monthly. If the annual rate is 12% the monthly rate will be 1%. By paying monthly there is no compounding of the interest rate. (Technically there could be if the rate was calculated and accrued daily but the impact would be negligible).

The interest rate can also float, meaning that it is charged as a fixed percentage over some form of base rate such as LIBOR, EUROBOR or bank prime rate. Since the base rate floats up and down each day a loan based on that rate is called a floating rate.

Borrowers typically prefer a fixed rate when they believe the base rate will hold steady or rise. Borrowers who think base rates are set to drop will prefer a floating rate.

Lenders who use leverage in their funds prefer to offer floating rate loans because they borrow money to fund some portion of their loans and this borrowing is typically done on a floating rate basis. Any increase in their costs will be matched by an increase in their revenues.

As I mentioned with fees, lenders work to reach a target rate of return. They can negotiate the interest rate but once you find that a lender is increasing another fee when reducing the interest rate you have probably reached his target return. Any changes at that point will help make a deal more agreeable for a borrower without changing the borrower’s view of the return the loan will generate.

PIK interest.

Not all loans require all of the interest to be paid in cash each month. Some lenders will include paid-in-kind, or PIK, interest. A loan may be written with 6% cash-pay and 6% PIK interest. Each month the borrower will pay the 0.5% monthly interest (which is 6% / 12) and 0.5% will accrue to the outstanding loan balance.

By accruing the 0.5% PIK interest, the amount will compound each month. The impact of this compounding is surprisingly modest. 36 months of interest at 0.5% (assuming no principal repayments) is 18% (which is 0.5% x 36). Compounding that amount raises the final payment to about 20%.