Subordinated Debt: Know Its Broader Potential

Subordinated or “junior” debt, may offer you a solution if you are raising capital for an established business with good cash flow but don’t have enough collateral to support your growth or acquisition plan. Sub debt is an important tool to consider when you feel caught in the gap between senior debt and equity and there are two types to know about.

The typical use of sub debt is as a credit enhancement to shoehorn senior debt into a deal that otherwise would not be bankable. Economic Development Groups (EDG) often use credit guarantees through the Business Finance Authority (BFA) or Small Business Administration (SBA) to reduce risk and exposure so that a loan can be secured from a traditional lender.

A different use of subordinated debt is where risk tolerant investors gain confidence based on a companies’ good growth potential and management expertise. These investors lend beyond collateral and rely on the CEO and management team’s business savvy and character. These loans can supplement bank debt or be the only debt in the deal. The advantage is that it does not dilute ownership, but claims are made against assets of the company to ensure repayment. With higher-risk deals, sub debt can be combined with warrants (a right to purchase stock in the future at an agreed-upon price). Sources include Vested for Growth (VfG), some Economic Development Groups, Angels or Mezzanine financiers.

Wild Things Inc., an established clothing manufacturer, grew when it used subordinated debt financing to complete a major US Army contract. The company provided our troops with an extreme cold weather clothing system. Entrepreneurial sub debt came from four lenders – Business Enterprise Development Company (BEDCO), Mt. Washington Valley Economic Development Corp (MWVEC), Northern Community Investment Corporation (NCIC), and Vested for Growth (VfG).