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Subordinated debt (sometimes also referred to as a subordinated loan, junior debt, subordinated bond, or subordinated debenture) is a debt that ranks below other, regular debt on a company’s balance sheet.
In the event the company faces bankruptcy or liquidation, subordinated debt will only be repaid after all other higher debt has been settled.
Since subordinated debt ranks below government tax liabilities, the liquidator, and other senior debt holders, it poses a higher risk to the lender.
Subordinated debt can be secured or unsecured and generally holds a lower credit rating than regular debt. This means it will typically cost the company more in finance charges (because it has a relatively higher interest rate) and consequently offer a higher yield to the lender. Typically, this type of debt carries an interest rate somewhere between 13% and 25%, and may also include equity kickers (or extra benefits) to further compensate the lender for the high risk and lack of asset security.
Examples of Subordinated Debt
There are many examples of subordinated debt. One such example is a bond issued by a bank. Such bonds tend to be especially risky because not only will the bondholder be repaid only after senior debt is retired, but they also lack the potential for upside gain traditionally enjoyed by shareholders.
Mezzanine debt is another example of subordinated debt. Mezzanine debt is a claim on a company’s assets. It is debt that is typically structured as an unsecured and subordinated note. Its position is senior only to common shareholders’ stock.
Another example of subordinated debt is an asset-backed security . These are often issued in tranches (or as a portion of a group of related securities), where the senior tranches are repaid first, followed by the subordinated tranches.
When a business owner agrees to sell their shares (or other form of ownership) to the company’s treasury in a buyout via company financing, it’s not unusual for the existing lenders to require the note payable to the former shareholder be subordinated to the existing debt. The subordination of a note payable in a shareholder buyout means the former shareholder may not be paid for their ownership sale if the business is not able to meet its other existing debt obligations.
Subordinated debt also includes common stock, which is subordinate to preferred stock, which is subordinate to a debenture (or unsecured bond), which is in-turn, subordinate to a secured mortgage bond.
How is Subordinated Debt Used?
Subordinated debt is used a number of ways. But for a small private company seeking growth, this kind of debt can provide a good opportunity to obtain capital for growth.
Despite the high interest rate typically associated with subordinated debt, a private company with good consistent cash flow has the potential to benefit from using this type of debt.
Business owners seeking to preserve their equity for a future sale and/or for compensation of key employees will find the ultimate cost of subordinated debt to be less than equity investments from outside sources. And for this reason, it’s typically considered seriously before seeking equity investors.