What is Subordinated Debt?

When things go wrong in a business, the most important question often becomes who gets paid first. That is the core concept behind subordinated debt.

It is a loan or security that ranks below other loans and securities regarding claims on a company’s assets or earnings. If a company goes bankrupt or liquidates, the subordinated debt holders get paid only after the senior debt holders are fully satisfied.

This structure makes it risky for the lender. Consequently, it usually comes with higher interest rates for you as the borrower.

For a founder, understanding this term is vital because it represents a specific lever you can pull when financing your operations. It sits in a unique spot between traditional bank loans and giving away shares of your company.

To understand where subordinated debt fits, you have to visualize the capital structure of your business as a stack or a hierarchy.

At the top, you have senior debt. These are typically secured loans from banks that are backed by collateral. They have the first claim on assets.

At the bottom, you have equity. That is the ownership stake held by you and your investors.

Subordinated debt sits right in the middle. It is often referred to as junior debt or mezzanine debt. Because it sits lower in the priority stack than senior debt, it holds more risk. In the event of a default, the senior lender takes what they are owed from the assets. The subordinated lender gets what is left over, if anything.

Comparing these two types of debt helps clarify the trade-offs involved in financing.

Senior debt focuses on security. Lenders look for collateral like equipment, inventory, or accounts receivable. Because their downside is protected, they charge lower interest rates.

Subordinated debt focuses on cash flow and enterprise value. Since these lenders cannot rely on being first in line for assets, they rely on the overall health and growth of the business.

• Cost: Subordinated debt is more expensive due to the increased risk.
• Covenants: Senior debt usually has strict rules on financial ratios. Subordinated debt may be more flexible but focuses on repayment capability.
• Equity Kickers: Subordinated lenders often ask for warrants. This gives them the right to buy a small percentage of stock at a set price, allowing them to participate in the upside if you succeed.

Why would a founder take on debt that costs more than a standard bank loan? It usually comes down to preserving ownership.

Raising capital through equity means permanent dilution. You give up a slice of the pie forever. Subordinated debt is temporary capital. You pay it back, and you retain your ownership percentage.

This type of financing is useful in specific scenarios:

• Acquisitions: You want to buy a competitor but do not want to use stock to pay for it.
• Growth Capital: You need to invest in sales and marketing to reach the next milestone before raising a Series B.
• Bridge Financing: You need to extend your runway to get to a better valuation.

While it prevents dilution, subordinated debt introduces a different kind of pressure. The required interest payments can strain your monthly cash flow.

You need to ask yourself if your projected revenue growth is reliable enough to service this debt. If your growth stalls, the debt burden can become unmanageable quickly.

There are also complexities regarding the intercreditor agreement. This is a contract between your senior and subordinated lenders. It dictates the rules of engagement between them.

Does taking this money tie your hands operationally? Will the senior lender allow you to make payments to the subordinated lender if your financial ratios dip slightly?

These are the questions you must answer before signing the term sheet. It is a tool for leverage, but like any lever, it amplifies both force and risk.