Subordinated debt: Overview, definition, and example
What is subordinated debt?
Subordinated debt refers to a type of loan or security that ranks below other debts in terms of repayment priority. If a company faces liquidation or bankruptcy, subordinated debt holders are repaid only after senior debt holders are paid in full. While subordinated debt carries higher risk for lenders, it often offers higher interest rates to compensate for the increased risk.
Why is subordinated debt important?
Subordinated debt plays a critical role in a company’s capital structure. It provides businesses with additional financing options while allowing senior creditors to maintain priority in repayment. For borrowers, subordinated debt can be a flexible way to raise capital without diluting equity or risking existing senior loans.
For lenders or investors, subordinated debt offers the potential for higher returns, but it comes with greater risk. Understanding its position in the repayment hierarchy is crucial for assessing the level of risk and reward.
Understanding subordinated debt through an example
Imagine a company secures a $1 million senior loan from a bank to fund its operations. Later, it issues $500,000 in subordinated debt to private investors for expansion. If the company struggles financially and must liquidate its assets, the bank (as the senior lender) is paid first. Only after the senior loan is repaid in full will any remaining funds go to the subordinated debt investors. If the assets are insufficient, the subordinated debt holders may not recover their full investment.
In another example, a startup uses subordinated debt to raise funds while preserving equity for future rounds of investment. The subordinated debt allows the startup to grow while keeping control of the company in the hands of the founders and early investors, albeit at the cost of higher interest payments.
An example of a subordinated debt clause
Here’s how a subordinated debt clause might appear in a contract:
“The Borrower acknowledges that this loan is subordinated to all existing and future senior indebtedness. Repayment of this subordinated debt shall occur only after all obligations under senior debt agreements have been satisfied.”
Conclusion
Subordinated debt offers businesses a flexible financing option, helping them raise capital without compromising equity or senior loans. However, it comes with increased risk for lenders due to its lower repayment priority. Including a clear subordinated debt clause in agreements ensures all parties understand their rights and obligations in the event of financial distress, making it a valuable tool in financial structuring.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.