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Subordinate debt, also commonly referred to as mezzanine financing, is a type of loan similar to debt financing in that the loan does have to be repaid and there is commonly a fixed interest component. It resembles equity in that repayment is usually based on the company’s cash flow and the lender’s position is subordinated to other lenders.
Why should I be interested in subordinate debt? Because it offers businesses a loan option that allows the repayment of principle to be deferred for up to 10 years and does not dilute the equity of the existing shareholders. Additionally, there is flexibility in the size of the loan. Depending on the lender, loans can be found ranging in size from $1 to $10 million.
Subordinate debt candidates must be able to clearly demonstrate the ability to generate cash flows that will cover repayment of all other debt plus the subordinated debt. Moreover, the lender will need to be confident that your management team is capable and able to make the operation successful.
Candidates should also note that interest costs can be anywhere from 2 to 8 percentage points higher than rates on other traditional loan products. Because subordinated debt usually has little collateral protection, the lender may require stock options to own equity in an amount equal to 1% to 10% of the company’s outstanding stock.
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