Meaning
Unsecured financial instruments represent a claim on assets that ranks below senior obligations in the event of default. A subordinated note acts as a bridge between pure debt and pure equity, often carrying a higher interest rate to compensate for the increased risk. It is a common tool in management buyouts or when a company needs more capital than a bank will provide.
Junior Debt
Priority of payment is the defining characteristic of this instrument. In a liquidation, the holder of a subordinated note only receives funds after all senior lenders and trade creditors are paid. This position makes the note more like equity in its risk profile but like debt in its fixed return.
The cost for the borrower is the higher yield demanded by the lender.
Yield Premium
Compensation for the risk of loss comes in the form of elevated interest payments. Because a subordinated note sits in a precarious position, the interest rate can be several percentage points higher than senior loans. This adds a substantial burden to the monthly cash flow of the business.
The founder must weigh this cost against the alternative of giving up more equity.
Recovery Prospect
Potential for repayment depends entirely on the surplus remaining after senior claims are settled. During a restructuring, these notes are often converted into equity as part of a settlement. This possibility changes the dynamic between the founder and the note holder.
