Subordinated Debt: How It Works And The Risks Involved

Small and larger businesses alike can take out loans to help them get started or finance business costs. One source of financing for business owners can be subordinated debt. Also called a subordinated debenture, this type of loan won’t require you to give up company equity, but it can present a risk for your lender since they’ll have no guarantee of repayment if your company goes under.

Let’s take a closer look at how subordinated debt works, its pros and cons and why it can be risky for lenders as well as borrowers.

Subordinated debt, in the corporate world, refers to an unsecured loan that’s repaid only after more prioritized debts and loans are paid off. It usually comes in the form of a loan from a bank, investor or other financial institution, and you later pay off the loan in monthly installments. Your creditor gets its money back through these monthly payments and earns a profit through the interest on this debt, which is typically tax-deductible.

Subordinated debt isn’t much different than any other type of loan your business might take on. The biggest difference is the order in which creditors get paid if a company defaults on its loans or goes out of business.

Subordinated Vs. Senior Debt

Another type of debt your business can take on is senior debt, also referred to as unsubordinated debt. This debt usually comes in the form of loans, unsecured as with subordinated debt. If your company shuts its doors or defaults on payments, creditors that provided senior debt get paid back first – before subordinated debt lenders. Only after these creditors receive their money do the providers or bondholders of subordinated debt get paid.

If there’s no money left after senior debt holders get paid, no one else gets paid, either. This can include subordinated debt holders, making subordinated debt a big risk for most investors.

Because of its position behind senior forms of debt, subordinated debt is often called junior debt.

Like all debt obligations, subordinated debt can be reported as a long-term liability on a company’s balance sheet. Long-term liabilities are listed in the order of repayment priority, so senior debt will come before any subordinated loans, debts or bonds. When a lender issues cash to a company as a loan, the business records the liability for that exact cash amount.

In the event of a bankruptcy and liquidation, a business will effectively default on all its loans and use its remaining assets to repay its creditors, with subordinated loans taking a lower priority. Senior loans take the highest priority in these instances.

Lenders thinking of issuing subordinated debt to a company will first observe the cash flow, solvency, existing debt obligations and total assets of that company before deciding whether to issue a loan. Lending subordinated debt is risky for investors because of their placement on the repayment hierarchy, which is why they’ll often issue a higher interest rate to cover potential losses.

All parties must adhere to bank regulations and subordination agreements when borrowing or lending subordinated debt.

Subordinated debt can come in various forms, such as those discussed below:

• Mezzanine debt: Falling between senior debt and a company’s equity in priority, mezzanine debt can have warrants and other investments attached to it. This type of subordinated debt is often ideal for growing companies because it’s based on predicted cash flows.
• Asset-backed securities: Multiple assets, such as loans, pooled together into a single investment are known as asset-backed securities (ABS) and often prioritized after any senior debt. Asset-backed securities are frequently divided in issuances, or tranches, to lower the risk to investors.
• High-yield bonds: Subordinated notes or bonds from a bank will often rank behind senior debt with regard to debt obligation. Subordinating bonds below senior level allows an issuer to incur debt in a cost-effective way, with varying risks based on a bond’s credit rating.

Axel DeAngelis, founder of online business name generator NameBounce, says the most important way to increase your odds of securing subordinate debt is to approach possible investors with an already profitable business.

That’s because investors and lenders run a higher risk of not getting paid with subordinated debt. These investors prefer to work with businesses that have healthy profits and cash flow. Businesses like this aren’t as likely to shut their doors and fail to repay their loans.

“The lender’s primary concern with repayment is making sure that you aren’t taking on too much debt relative to the profitability of your business,” DeAngelis says.

Calloway Cook, president of dietary supplement seller Illuminate Labs, says businesses that want to attract subordinated debt must have a good business credit score, too. Such a score shows that your company has a history of paying bills and debts on time – something that’s especially important to lenders and investors when riskier subordinated debt is involved.

“Creditors looking to receive interest payments from subordinated debtors are at a higher risk of default than creditors receiving interest from unsubordinated loans,” Cook says. “Since the creditor is accepting a higher risk for a higher rate of interest, they are extremely diligent about analyzing how well the company has repaid debts in the past.”

Peter Mead, former head of marketing for Bitcoin Australia, says companies are more likely to attract subordinated debt if they first make sure that their financial records are in perfect order. It helps, too, if companies can show investors realistic revenue and profit projections.

“Sub debt is a high risk to the banks,” Mead says. “So, extra reassurance is needed for them to come on board with your request – usually at a higher interest rate to the business because of the decreased priority of paying the loan back after other potential creditors.”

Larger corporations may have the assets and cash flow to back up their subordinated debt, but small businesses just starting out may have trouble qualifying for a loan when the lender risks not being repaid. The good news is that it’s possible to finance a small business through other means, which include:

• Personal loans: A personal loan is most often a loan of $1,000 – $50,000 that a borrower can use for various purposes, which include making a large purchase and funding a budding business. Most personal loans are unsecured and repaid in monthly installments. The application process can be faster and more straightforward than with other loan types.
• 0% APR credit cards: Credit cards can provide a small loan for business owners, but they generally come with a higher interest rate than several other loan options. Some lenders offer a 0% APR introductory period for new cards, allowing for 6 – 21 months of interest-free payments.
• Crowdfunding: Websites such ascom can allow business owners to crowdfund money from a large pool of potential investors or customers. Crowdfunding isn’t always a sure thing though, and you could fall short of your financial goal.

Subordinated debt naturally carries both benefits and risks. Next, we’ll briefly consider how this debt instrument can be put to positive and not-so-positive use.

Pros

According to DeAngelis, the biggest benefit of subordinated debt is that taking it on won’t require you to give up equity ownership in your company.

“If you’re reasonably certain that the additional capital will lead to growth, then subordinated debt will likely turn out to be much cheaper than equity,” DeAngelis says.

Cons

As mentioned, subordinated debt has its downsides, too. DeAngelis says the weight of debt payments can crush a business, even if that company has existed for decades.

Another downside is higher interest rates, since subordinated debt is riskier for lenders. These loans, then, are typically more costly to business owners than senior or unsubordinated debt.

“Always look to take on unsubordinated debt first,” Cook says.

Still have questions about subordinated debt? See if we’ve answered them below.

What’s an example of subordinated debt?

Subordinated debt can refer to any debts that fall behind senior debt in priority, but ahead of the common equity belonging to a business. One example can be bonds issued by banks or asset-backed securities.

Does subordinated debt count as equity?

Subordinated debt is different from equity debt. With equity debt, you get investment dollars, but you must also give up part of your equity – or ownership – in the company for these dollars.

For instance: You might get $250,000 from an equity investor, but you’ll have to give that investor 10% equity in your business. This investor now owns 10% of your company.

Why do banks and creditors issue subordinated debt?

Banks typically issue senior debt, which carries less risk, but when interest rates are lower, banks may also issue subordinated debt to build up their capital. Interest payments on subordinated debt are also tax-deductible, making them an inexpensive way for banks to replace higher-cost capital and meet regulatory requirements.

You might not need to take on subordinated debt to fund your business, but it’s still an option that may be worth keeping in mind. The key is understanding the pros and cons so you can then make the right decision on whether subordinated debt can help you successfully grow your small business.

If you believe a personal loan might be a better option for you, you can get started today with Rocket Loans℠ and see the rate you prequalify for.