What is Senior Debt?

Senior debt is a financial term that defines who gets paid first. When a company borrows money, not all loans are created equal. Some lenders demand to be at the front of the repayment line.

That position is what makes the debt senior.

If your startup fails or faces liquidation, the proceeds from selling assets go to the holders of senior debt before anyone else sees a dime. This includes other lenders, suppliers, and certainly equity holders.

The concept of seniority relies on a hierarchy of claims. This is often referred to as the capital stack.

Senior lenders take on the least amount of risk compared to other capital providers. Because they have the first claim on assets, they are most likely to recover their principal if the business goes under.

Due to this reduced risk, senior debt usually carries the lowest interest rates available to a company.

This sounds beneficial for the borrower, but it comes with strict requirements. Senior lenders generally require the loan to be secured by collateral. This could be specific assets like machinery or a blanket lien on intellectual property, inventory, and accounts receivable.

To fully understand senior debt, you have to look at what sits below it. This is often called junior or subordinated debt.

Junior debt holders agree to be paid only after the senior debt obligations are fully satisfied. Because they stand further back in the line, they face a much higher probability of total loss.

Here is how they generally differ:

• Risk: Senior debt is lower risk. Junior debt is higher risk.
• Cost: Senior debt has lower interest rates. Junior debt charges higher rates to compensate for the risk of not getting paid.
• Security: Senior debt is almost always secured. Junior debt is often unsecured.

In a startup context, convertible notes often behave like junior debt until they convert to equity. They usually sit behind the bank loans or venture debt facilities.

You will likely encounter senior debt when you look for venture debt or a revolving line of credit from a bank.

Commercial banks and specialized venture debt funds are the primary issuers of this type of capital. They provide cash to extend your runway, bridge to a new round, or finance equipment.

When they issue this debt, they typically file a UCC-1 financing statement. This filing effectively puts a public lien on your business assets.

It creates a relationship where the lender has significant leverage. If you break a financial covenant or miss a payment, they have the legal right to seize assets to make themselves whole. This can effectively shut down operations overnight.

Taking on senior debt is a major decision for a founding team. It is often cheaper than equity because it is non-dilutive. You do not give up shares of your company to get it, which preserves your ownership stake.

However, it reduces your financial flexibility.

Future lenders will hesitate to lend to you because they do not want to be in a junior position. You have to ask yourself if the immediate capital is worth the restrictions placed on your future financial moves.

Does the lower cost of capital outweigh the risk of pledging your assets?

There are also unknowns to consider regarding how aggressive a specific lender might be during a downturn. Not all lenders react to missed covenants the same way. It is worth investigating a lender’s reputation before signing the term sheet to understand how they behave when things get difficult.