What Is Subordinated Debt?
So you need money to help grow or start your small business. Fortunately, you have options: You can give up equity in your company to attract investors. Or, you can take out loans from several sources. In that case, you might consider subordinated debt.
What Does Subordinated Debt Offer?
Subordinated debt usually comes in the form of a loan from a bank, investor or other financial institution. You then pay this loan back in monthly installments, with interest.
Your creditor gets its money back through these monthly payments. It makes its profits through the interest on this debt.
Subordinated debt isn’t much different from any other type of loan your business can take on. The biggest difference is the order in which creditors get paid should a company default on its loans or go out of business.
What Is The Difference Between Senior Debt And Subordinated Debt?
Another type of debt your business can take on is senior debt. This type usually comes in the form of loans, unsecured as with subordinated debt. But if your company goes out of business or defaults on its payments, creditors that provided senior debt get paid back first. Only after these creditors receive their money do the providers of subordinated debt get paid.
What if there’s no money left after senior debt creditors get paid? Well then no one else gets paid, including those investors who provided subordinated debt. This makes subordinated debt riskier for most investors.
Wait, What Is Junior Subordinated Debt And How Can My Business Get It?
Because of its position behind senior forms of debt, subordinated debt is often called junior debt.
What can you do to boost your business’ odds of attracting this type of debt from investors or banks? Axel DeAngelis, founder of Walnut, California-based NameBounce, an online business name generator, says the most important way to increase your odds of securing subordinate debt is to approach possible investors with a business that is already profitable.
That’s because investors and lenders run a higher risk of not getting paid with subordinated debt. These investors, then, prefer to work with businesses with healthy profits and cash flow. These businesses aren't as likely to shut their doors and not 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 Northampton, Massachusetts-based Illuminate Labs, which sells dietary supplements, 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 it comes to riskier subordinated debt.
"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, head of marketing for Bitcoin Australia, says that 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, 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," Mead says.
You do have options when looking for a loan for your business. A personal loan can help give your small business a push.
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.
Pros Of Subordinated Debt
The biggest benefit of subordinated debt is that taking it on won't require you to give up equity ownership in your company, DeAngelis says.
"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 Of Subordinated Debt
There are downsides to subordinated debt, or any kind of debt, though. DeAngelis says that the weight of debt payments can crush a business, even if that company has existed for decades. He points to company Toys "R" Us, which recently went out of business largely because of how much debt it owed.
If you take on too much debt – of any kind – you might put your business in danger, DeAngelis said.
Another downside? Since subordinated debt is riskier for lenders, it comes with higher interest rates. 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.
You might not need to take on subordinated debt to fund your business. But it is still an option to keep 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.
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