What Is Subordinated Debt?

Small and larger businesses alike can take out different loans to help them get started or to finance business costs. One source of financing for business owners can be subordinated debt. This type of loan won’t require you to give up company equity, but can be a risk for your lender, as there’s no guarantee they’ll be repaid should your company go under.

This article will further explain how subordinated debt works, its pros and cons and why it can be a risk for lenders.

Subordinated debt, in the corporate world, refers to an unsecured loan that’s repaid only after more prioritized debts and loans are paid off. It 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, which is typically tax-deductible.

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. In the event of a bankruptcy and liquidation, a business will effectively default on all its loans and use its remaining assets to repay its creditors, with subordinated loans taking a lower priority.

Another type of debt your business can take on is senior debt, also referred to as unsubordinated 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.

In the event that there's no money left after senior debt creditors get paid, then no one else gets paid, either. This can include those debt holders who provided subordinated debt, making subordinated debt a big risk for most investors.

Because of its position behind senior forms of debt, subordinated debt is often called junior debt.

Axel DeAngelis, founder of 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 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 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.

Sub Debt Alternatives

Larger corporations may have the assets and cash flow to back up their subordinated debt, but small businesses just starting out may have trouble qualifying for a loan when the lender risks not being repaid. Fortunately, there are other options for financing a small business, such as the following:

• Personal loans: A personal loan is a loan of $1,000 – $50,000 that a borrower can use for almost any purpose, from making a large purchase to funding a budding business. Most personal loans are unsecured, depending largely on the applicant’s credit score. and are repaid in monthly installments. The application process can be faster and more straightforward than other types of loan.
• 0% APR credit cards: Credit cards can provide a small loan for business owners, but they can come with higher interest rates than other loan options. Some lenders offer 0% APR introductory periods for new cards, allowing 12 – 18 months of interest-free repayment periods.
• Crowdfunding: Sites like Kickstarter.com can allow business owners to crowdfund money from a large pool of potential investors or customers. Crowdfunding isn’t always a sure thing though, and you could fall short of your financial goal.

Pros

According to DeAngelis, the biggest benefit of subordinated debt is that taking it on won't require you to give up equity ownership in your company.

"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

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 the company Toys "R" Us, which went out of business largely because of how much debt it owed.

Another downside is higher interest rates, since subordinated debt is riskier for lenders. 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.

What’s an example of subordinated debt?

Subordinated debt can refer to any debts that fall behind senior debt in priority, but ahead of a business’s common equity. One example can be bonds issued by banks or asset-backed securities.

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.

Why do banks and creditors issue subordinated debt?

Banks will typically issue the less-risky senior debt, but may issue subordinated debt in times of lower rates in order to build up their capital. Interest payments on subordinated debt are also tax-deductible, making them an inexpensive way for banks to replace higher-cost capital and meet regulatory requirements. 

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.

If you believe a personal loan might be a better option for you, you can get started today with Rocket Loans℠ and see what rates you qualify for.