What Are The Risks of Subordinated Loans?

Subordinated loans are arranged as secondary financing to cover any additional funds you need beyond the loans you secured from your primary lender. These loans typically originate from private investors, mutual funds or hedge funds rather than through large banks. They are called subordinated loans because they have a lower priority than your senior loans. If you declare bankruptcy, the courts will pay off the subordinate loans only after senior debts have been settled. Subordinated loans are necessary at times for those ventures that require a high degree of capital and a high degree of risk. The loans have risks of their own, however.

High Costs

Any time you are arranging financing for your business you must consider the cost of the loans. Senior loans will be arranged based on your credit score and financial health, and they generally have a predictable interest rate. Subordinate loans, however, will rely mostly on your business plan. Subordinate lenders are more likely to take on a high risk loan if the business plan shows a high potential for future profits. Their willingness to take on a high risk loan does not come free, however. They will charge you more for the service than a senior lender.

Sharing Equity

The primary way subordinate lenders charge you more for your loan is through an equity structure. They take an ownership stake in your company, either through stocks, profit sharing agreements or joint venture status. This usually means the subordinate lender will get next to nothing in case of liquidation. However, if the company does well, you will be sharing ownership of the company and all the profits with your subordinate lender. Some borrowers choose to "buy out" the lender in the future. This will be costly, though, and is not always an easy agreement to negotiate.

Restrictive Terms & Slow Lending Cycle

The subordinate lender has more at stake in your success or failure. They will take a much closer look at the loan terms than many senior lenders. Included in the loan terms may be clauses restricting you from refinancing your other loans, seeking more loans or taking a salary above a certain cap. While the loans are very flexible because they use many different methods to assure stability of the company, they will ultimately be much more restrictive than senior loans. The time it takes to agree on these loan terms can prevent you from carrying out your business. It is not unheard of for a subordinate loan to take three months or more to originate fully.

Sharing Control

Many business owners are independent-minded people who are looking to do things their own way. Sharing equity in a company means sharing control of that company. The degree of control you allow the subordinate lender to have depends on your agreement. Some will want a voting place on the board while others will be okay with an advisory position. In all cases, though, the subordinate lender will have a bigger hand in the future of your business than a straight financing arrangement from a senior lender.