When a business borrows money, it typically goes to a bank to receive a loan. A business loan is often secured by collateral such as a lien on all business assets or a real estate mortgage. It’s very common for businesses to borrow money from multiple sources, so how do lenders know who will be paid first in a bankruptcy or liquidation scenario? The answer is the concepts known as senior and subordinated debt.
Subordinated Debt Definition
Subordinated debt, also known as a subordinated debenture or subordinated loan, are debts or claims that have a lower priority over other debts or claims regarding repayment. In a bankruptcy or liquidation scenario, creditors who own subordinated debt will not be repaid until the creditors who own senior debt have.
Subordinated Debt vs. Senior Debt
Senior debt includes loans to business that are secured by collateral, and are first in line when it comes to repayment. Subordinated debt on the other hand is often unsecured and can either be interest bearing or non-interest bearing. In the event of liquidation, all senior debt will be paid before subordinated debt.
Subordinated Debt Example
Pretend a local restaurant has existing debt on its balance sheet. Maybe the owner received a start-up loan from a friend and is slowly paying it back with interest. If the restaurant wants to expand, it may go to a bank for another loan. When banks lend money, they want to minimize risk as much as possible, so it is common they will require all other debt to be subordinate to theirs. They do this to protect their interests and make certain they will be paid back first in a liquidation scenario.
If the local restaurant were to go bankrupt, a court would likely decide the order in which its creditors would be paid back. The bank would be repaid first (due to the subordination of all other debt) and if assets still remain, the friend would be paid back next. Any assets that still remained after both the bank and friend were paid back would go to the restaurant owner.
Balance Sheet Reporting
Similar to all debt obligations, subordinated debt is classified as a liability on a businesses balance sheet. Balance sheet liabilities are broken into two categories: current and non-current.
Current liabilities are listed first. Beneath current liabilities are non-current liabilities (also called long-term liabilities). Senior and subordinated debt should be listed in order of payment priority, with the more senior debt above any subordinate debt.
Both senior and subordinated debt are normally classified as non-current liabilities, since bank debt is often paid over a period longer than one year. The portion of debt paid within the next 12 months is referred to as the current portion of long-term debt.
Overall, subordinated debt is an important concept to understand when working in commercial banking, corporate finance, and even investment banking. Knowing the order of who gets paid first is crucial when analyzing a company or deciding whether or not you want to extend credit to them.