Senior Debt: Everything You Need to Know
Senior debt is the debt that is paid back first if the borrower runs into trouble paying back debt and is the lowest cost and most common funding available.5 min read
Senior Debt: What Is It?
Senior debt is the debt that is paid back first if the borrower runs into trouble paying back debt. It's the lowest cost and most common funding available, often from a bank. Banks can lend money for a small percent, such as 2 to 5 percent, and in return, they get prioritized as senior debt.
Senior gets first priority and must be repaid first before any other creditors receive payments. These less important debts are called junior debts. Senior debt is typically from a bank and banks can provide you with lower interest rates (after all, they have all that "free" money that people put into their savings account that they can lend out).
This saves you big time when it comes to how much you'll pay in interest. Bank loans typically come with 2 to 5 percent in interest, whereas junior debt lenders come in at about 5 to 12 percent. As long as you make the required payments to banks on top and in full, senior debt lenders don't have any control in your business.
Why Is Senior Debt Important?
Because senior debt has the lowest interest rates, they're typically the first type of loan sought after. Banks and senior debt lenders use this to their advantage by expecting borrowers to prove they are low-risk investments and by prioritizing their payback above other debts that the company may have.
For example, let's say that you need $1 million to get your business up and going. After 5 years, the business will be at its peak and ready to sell. Whether you get the funding from a bank for from a junior debt lender, the result will be the same: You'll be able to sell the business for $5 million.
If you borrow the money from a bank at 5 percent, assuming you're making payments on just interest, you'll have paid $250,000. If you were to borrow from a junior lender at 12 percent, however, the total amount you would pay in interest is $600,000. That's a difference of $350,000 that you would have been able to keep for yourself. Now think about the effect if what you borrowed was 10 times that. It would be a difference of $3.5 million.
Having senior debt can save you a lot of money, but they aren't willing to take on as much risk. That's why senior debt lenders have interest rates that are lower and junior debt lenders have interest rates that are higher. For junior lenders, they figure if they aren't going to get paid back first, at least they took more of your money to begin with through higher interest payments.
Lenders will also offer higher interest rates if they see the borrower as a high risk, which may lead to missed or delayed payments. If borrowers can show they have a history of having strong cash flow, it's possible to get interest rates as low as one point below prime.
Not Getting Senior Debt: Advantages and Disadvantages
Senior debt has a lot of advantages. Even so, here are some pluses and minuses if you choose not to get senior debt.
- You're more likely to get a larger amount. If you need $10 million, for example, you're more likely to be successful with a junior debt lender.
- If you go with a venture capitalist to invest in your company instead, you'll have an experienced partner who will help you learn more about owning a business. Perfect for those who are inexperienced or need a partner with connections.
- Also, with venture capital, you won't have to worry about making payments or risk defaulting on a loan.
- If you are seen as a greater risk, junior loan lenders are more likely to be willing to take on that risk, though the interest rate may be higher.
- If you go with funding from a different source, you may end up getting less out of the venture. For example, if you go with a junior lender, you'll pay a higher amount in interest. If you go with a venture capitalist, you will likely end up earning less because of splitting the revenue.
- If you go with a venture capitalist, you'll have to get approval to make key decisions, such as acquiring another company or selling the company.
Getting Senior Debt: Advantages and Disadvantages
If you're considering getting senior debt, here are some good and bad things about it that you might not have thought about.
- You can get great interest rates when it comes to senior debt. The more you can show that it's a low-risk investment, the lower your interest rate will be.
- Senior debt is available for anyone to apply, though to be approved you'll need to meet strict guidelines.
- Because the interest rates are lower, you'll save money over other loans, whether you decide to sell your company or not.
- Senior debt is a low-risk sort of loan. They won't let you have money without having collateral to back up that loan. This typically involves assets of the business itself. With that in mind, you're taking a risk to borrow that money, and should only do so if you're reasonably sure you'll be able to pay it back.
- Depending on the amount you need, you may not be able to get a big enough loan through a bank. They generally have less money to give out than junior debt lenders.
- If you have a secured senior debt loan and you default on your payments, the lender can come after the assets that were used to secure the loan.
Frequently Asked Questions
- What is the difference between senior debt and mezzanine debt?
Mezzanine debt combines a loan with an investment. Mezzanine debt lenders use different criteria for approving borrowers. They look at the company's earnings before interest, tax, depreciation, and amortization as well as looking at the quality of the business's leaders. The interest rates are higher with mezzanine debt than senior debt. They also receive warrants as part of the deal. Where senior debt lenders only care about getting paid back, mezzanine debt providers are concerned with the future of a company and its profitability.
- What is unsecured vs. secured debt?
Secured debt takes priority over unsecured debt in the hierarchy of senior debt. Secured debt is backed by collateral, specific items that have liens placed against them and are sold to pay back the money owed. Unsecured debt does not have collateral backing it. Instead, lenders of unsecured debt file claims against the company itself to try and get paid by the company's general assets.
If you need help with questions about senior debt or anything else related to your business, your best bet is to post your question or concern in UpCounsel's marketplace. You can get connected to one of the many qualified lawyers. UpCounsel only accepts the top 5 percent of lawyers onto its site. The lawyers that you'll find on UpCounsel have an average of 14 years of experience, including time working with or for companies like Google, Stripe, and Twilio, and come from law schools such as Harvard and Yale.