Subordinated debt can be a good debt financing instrument for startups, small and mid-sized businesses if you can get it, but, unfortunately, subordinated debt financing is not as easy to get as you might think.
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As is the case with senior debt, many times pre-revenue start-ups will be unable to secure a subordinated debt from a lender because they lack a history of stable cash flows.
Unlike senior debt, however, subordinated debt does not require a pledging of assets, and is considered unsecured debt. This means that in the case of a default, the lender is only entitled to the equity of the company and what is left after all of the lenders of senior debt have been repaid.
From a lender's perspective, subordinated debt financing is an incredibly risky form of lending and thus carries a high interest rate.
In addition to the increased interest rate, lenders of subordinated debt will often require the company to issue warrants or convertible bonds (which the lender can choose to redeem as shares) as insurance against a default. Lenders of subordinated debt have priority over only common stock holders in the reimbursement schedule.
Due to the risky nature of subordinated debt, banks are not nearly as willing to offer this form of financing as they are with senior debt, which has first priority to be repaid and is backed by a specific asset.
Oftentimes, the lenders of subordinated debt will be a parent company or a specialized subordinated debt-lending institution.
The lender must ensure they have detailed knowledge of the operations and financial performance of the company seeking subordinated debt. Although interest payments will be higher, there is a much greater chance the lender will not be repaid its debt in the case of a default. Subordinated debt is usually issued only after the company has taken out the maximum amount of senior debt a lender is willing to offer. Higher levels of subordinated debt can be found in leveraged buyouts of companies and other highly leveraged transactions.
If a company that has been issued subordinated debt defaults and has lost all — or almost all — of its equity value, then the lender is only able to recover their assets by filing suit and demanding a court order for the repayment of the amount. Due to the collateral obligations of senior debt, banks will be repaid before any concerns of the lenders of subordinated debt are addressed, thus leaving them with the same fate as shareholders.
Understanding the distinguishing factors among the different types of debt is an important part of being aware of the financing options available to you as an entrepreneur. While senior debt comes at a cheaper rate, it also requires much more responsibility and carries more restrictions than subordinated debt.