Subordination of intercompany indebtedness: Overview, definition, and example
What is subordination of intercompany indebtedness?
Subordination of intercompany indebtedness refers to a situation where one company agrees to prioritize another party’s debt over its own debt in the case of liquidation or bankruptcy. Specifically, in the context of intercompany indebtedness, it means that a subsidiary or a related company agrees that any money owed to them will be paid only after other external creditors (such as banks or suppliers) have been paid in full. In other words, the intercompany debt is subordinated to the debt held by third parties.
In simpler terms, subordination of intercompany indebtedness means that one company agrees to wait for its payment until all other outside creditors are paid first.
Why is subordination of intercompany indebtedness important?
Subordination of intercompany indebtedness is important because it helps businesses manage their financial structure and make themselves more attractive to external lenders or investors. By subordinating intercompany loans, a company can show that it is committed to honoring its obligations to outside creditors first, which can make it easier to secure financing. It also provides a clear ranking of debt obligations in case the company faces financial difficulties or bankruptcy.
For SMB owners, understanding and using subordination of intercompany indebtedness can be key when seeking loans or investments from external parties, as it demonstrates a commitment to meeting obligations in an orderly manner.
Understanding subordination of intercompany indebtedness through an example
Let’s say your company has a loan from a bank and also owes money to a subsidiary. You want to borrow more money from the bank, but the bank insists that the debt owed to the subsidiary be subordinated, meaning the bank's loan must be paid first if your company runs into financial trouble. By agreeing to subordinate the intercompany debt, your company shows the bank that it will honor the external loan first, making it more likely that the bank will approve additional financing.
In this case, the subordination of intercompany indebtedness ensures that the bank’s claim takes priority over the debt to the subsidiary.
Example of a subordination of intercompany indebtedness clause
Here’s an example of what a subordination of intercompany indebtedness clause might look like in a financing agreement:
“The Borrower agrees that any indebtedness owed to its parent company, [Parent Company Name], shall be subordinated to the debt owed to the Lender. In the event of liquidation or bankruptcy, the Borrower will prioritize repayment of the Lender’s debt before repaying the subordinated intercompany indebtedness.”
Conclusion
Subordination of intercompany indebtedness is a strategic financial tool that helps prioritize debt obligations and make a company more appealing to external creditors. For SMB owners, understanding how to subordinate intercompany debt can provide greater access to financing and show commitment to fulfilling external obligations. By clearly defining the hierarchy of debt, this practice ensures that companies can maintain strong relationships with lenders and avoid conflicts in the event of financial difficulty.
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.