SUBORDINATED LOANS
Subordinated loans are unsecured loans that rank behind other claims (like senior debt) in the event of payment difficulties. When a company is financially healthy, subordinated loans operate much like traditional loans. This changes during times of financial difficulty: if a qualified subordination agreement is in place, the lender's claims take a lower priority and are only enforceable if the company is financially able to meet them. This means that their repayment occurs only after higher-ranking (secured) creditors have been settled, and if repayment doesn’t risk the company’s insolvency, otherwise it can be further delayed or suspended. This greater participation in the company's risk sets subordinated loans apart from traditional senior debt.
You might be wondering: who would agree to that? Well, it is a risk, but one for which investors can be adequately compensated for. Subordinated loans can be a good option for investors who are willing to take on equity-like risks but without assuming all the risks of equity, and who are also enjoying the simplicity of a loan agreement.
Subordinated loans – much like traditional loans – seem like a good fit for steward-ownership-aligned financing, still, there are some considerations to keep in mind:
- Make sure that you have a good due diligence process also with these instruments (e.g. look out for covenants that could grant ownership rights under certain conditions).
- There are many possibilities for structuring the terms. For instance, interest might be paid only until a predetermined multiple of the principal is repaid; or interest increases if the company’s profit exceeds a certain threshold, up to a maximum interest level and repayment amount.
- Due to the increased risk compared to e.g. senior debt, the loan agreement might include broader information or approval rights for the lender, such as approval rights for when taking on additional loans.
- If you’re planning follow-up financing rounds or seeking funding options with strict regulations on equity recognition (such as state funding), be aware that subordinated loans may or may not be treated economically as equity, depending on the financial institution’s policies. This uncertainty could risk temporary balance sheet over-indebtedness and limit access to these funding options.
- Be aware that subordinated loans may have certain tax implications for investors, such as the "dry income" issue, where taxes on interest or dividends are due before any payments are received. This can create a cash flow mismatch for the investor, as they need to cover the tax liability out of pocket before receiving the actual interest payments. Whether interest is taxed as income or dividends depends on the specific contract terms and tax authority regulations.
- On the other hand, subordinated loans may offer a quicker path to liquidity for investors, as they can often be repaid without first covering past losses. Additionally, in the case of insolvency, subordinated loans are prioritized over equity.
Although subordinated loans are often used in start-up financing, in our experience, they may rather be useful for addressing short-term financing needs, or can serve as a bridge solution for companies in their growth stage or young companies after the proof-of-concept stage. For start-ups looking to establish a long-term financing structure, subordinated loans may be less ideal. The reason is that subordinated loans might not be flexible enough to capture the potential reward (“upside”) when applied to a startup with an uncertain future. Interest rates and repayment terms are typically agreed upon, meaning they do not adapt as the company grows or succeeds, nor do they share in the associated risks. This often makes the instrument more attractive for later stages of a company's development. That said, there are ways to make subordinated loans more flexible, such as structuring them as profit participation loans.
(beyond those outlined under debt capital)
