Subordinated Debt (aka “sub-debt” or mezzanine financing)

WHAT IT IS

according to Wikipedia:

 

In finance, subordinated debt (also known as subordinated loansubordinated bondsubordinated debenture or junior debt) is debt which ranks after other debts should a company fall in to liquidation or bankruptcy.

 

Such debt is referred to as ‘subordinate’, because the debt providers (the lenders) have subordinate status in relationship to the normal debt. A typical example for this would be when a promoter of a company invests money in the form of debt rather than in the form of stock. In the case of liquidation (e.g. the company winds up its affairs and dissolves), the promoter would be paid just before stockholders — assuming there are assets to distribute after all other liabilities and debts have been paid.

 

Subordinated debt has a lower priority than other bonds of the issuer in case of liquidation during bankruptcy, and ranks below the liquidator, government tax authorities and senior debt holders in the hierarchy of creditors. Because subordinated debts are repayable after other debts have been paid, they are more risky for the lender of the money. The debts may be secured or unsecured, but have a lower ranking priority than that of any senior debt claim on the same asset.

 

Subordinated loans typically have a lower credit rating, and, therefore, a higher yield than senior debt. While subordinated debt may be issued in a public offering, major shareholders and parent companies are more frequent buyers of subordinated loans.

 

WHERE TO BORROW

Most lenders lend against assets. In other words they register an interest in the borrower’s property as collateral, in case the borrower defaults on the loan. However some commercial lenders – or “quasi-commercial lenders” do issue sub-debt to growing companies that have turned the corner to profitability. For these emerging companies, sub-debt can be an alternative to asset-backed borrowing.

Clearly sub-debt is expensive when compared to more traditional asset-backed loans. However it is much cheaper than equity financing.

Not all lenders offer subordinated debt products. In Canada the Business Development Bank http://www.bdc.ca/EN/solutions/subordinate_financing/Pages/default.aspx is one alternative. For BC-based companies VanCity offers alternatives as well https://www.vancity.com/BusinessBanking/Financing/GrowthCapital/

 

HOW TO USE SUB-DEBT

Here are some typical scenarios:

Management buyouts Subordinate financing can provide the necessary funds for an existing management team to invest in a company and launch an MBO.
Mergers & Acquisitions Naturally involve both fixed assets and more difficult-to-finance intangible assets such as “goodwill.” Subordinate financing can help companies purchase the goodwill while preserving their cash flow during a period where some uncertainty may exist.
Working capital for growth Subordinate financing is often used to finance working capital for growth, which enables companies to increase revenues and profits. Entrepreneurs looking to invest money in market penetration, improve product R&D or finance additional headcount can take advantage of subordinate financing without compromising their regular cash flow used for daily operations.

 

Published by Rob Farrow

accountant, entrepreneur, former chef, occasional artist, angel investor, business advisor, corporate tax specialist

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