Subordination of securities: Overview, definition, and example

What is subordination of securities?

Subordination of securities refers to an agreement that ranks one debt or security lower than another in terms of repayment priority. If a company goes bankrupt or defaults, subordinated securities are paid only after higher-ranking debts, such as senior loans, are fully repaid.

For example, in a company’s capital structure, secured loans and senior bonds are typically paid first, while subordinated bonds or convertible debt are repaid last, increasing the risk for investors holding those securities.

Why is subordination of securities important?

Subordination matters because it determines the order in which creditors are paid in case of financial trouble. Investors in subordinated securities take on more risk but may receive higher returns as compensation.

For lenders and businesses, subordination agreements help clarify financial obligations and protect senior creditors. Many loan agreements and bond issuances include subordination clauses to define repayment priorities.

Understanding subordination of securities through an example

Imagine a company has two types of loans:

• A senior loan of $1 million from a bank, secured by company assets.
• A subordinated loan of $500,000 from a private investor.

If the company declares bankruptcy, the bank is repaid first. The private investor receives repayment only if there are remaining funds, increasing their financial risk.

In another case, a startup raises money through subordinated convertible bonds. These bonds rank below traditional bank loans, meaning if the startup fails, bondholders may not be repaid until all senior debts are settled.

An example of a subordination of securities clause

Here’s how a subordination clause might appear in an agreement:

Conclusion

Subordination of securities establishes a ranking system for debts and securities, affecting repayment priority in case of default or bankruptcy. Investors in subordinated securities take on greater risk but may receive higher returns.

Frequently asked questions (FAQs)