Subordinated Loans: How They Are Used

Subordinated loans are typically extended by lenders without use of collateral in exchange for a portion of equity in the company. Subordinated loans are used when the company seeking financing cannot arrange enough liquidity through a primary lender and must seek alternative sources. Typically, the borrower is seeking financing that is considered risky either due to the nature of the venture or the financial history of the borrower. Shopping around on the private loan market can often yield more than traditional banks and lenders.

Financing Is Secured through Senior Lender

Companies will first arrange a certain amount of financing through a senior lender. This is typically a public company like a bank, insurance company or dedicated financing institution. This loan will be the senior loan meaning it will be the first paid off in case the borrower goes bankrupt. This type of loan may be secured, utilizing collateral, or unsecured. The interest rates on the senior loan tend to be lower than those on the subordinate loan.

Remainder of Financing Is Sought with Subordinate Lender

If the company determines it requires additional financing, it can first seek that financing through the senior lender. Often, the senior lender will have a loan limit lower than the total amount needed, however. The company looking for a commercial loan then takes its business plan and needs to the subordinate market. Here, the company looks to mutual funds, private equity groups or investors to take on the remainder of the financing. The business plan is an essential part of this process. With senior lenders, a company's financial solvency will be of primary issue. With subordinate lenders, future potential earnings become a main concern.

Debt to Equity Agreement Is Made

The original borrower and subordinate lender enter discussions for the remaining financing. In an unsecured subordinate loan, a portion of the original debt is transferred into equity. This means the subordinate lenders become shareholders in the company. They will typically ask for a portion of future earnings, called a profit split, or yields and dividends on the stock they possess. The agreements can take awhile to develop and sign because the loan is riskier and often more complicated. However, subordinate loans tend to be very flexible as the lender has a personal interest in getting the best terms arranged for the borrower to succeed.

Subordinate Lender Holds Stake in Company

Once financing is extended, the subordinate lender holds a stake in the future earnings of the company. In some cases, the lender may have a vote in company decisions or a seat on the board of directors. In others, the lender simply arranges very specific terms in the original loan. These terms may restrict the borrower from seeking more financing, refinancing any other loans or carrying out a variety of other actions. In any case, the subordinate lender will have a say in what the company can and cannot due.