Any subordinated promissory note definition covers all agreements made between a borrower and investors in which the repayment of any debts, in the event of a default, happens after all other debts owed by the borrower are repaid. They represent a hybrid form of financing a business that is characteristic of the two more traditional forms of financing: debt and equity.

A subordinated promissory note gets its name because all claims to debt are subordinated below the claims on assets or earnings made by all other debtors. A subordinated promissory note is therefore a high risk/high reward investment in a company.

Why Do Subordinated Promissory Notes Exist?

Also referred to as a junior security or subordinated loan, a subordinated promissory note has features that make it appealing to both the company doing the borrowing and investors in the company’s business.

  • Companies use subordinated promissory notes as a relatively inexpensive way to raise funds without draining or tying up equity. They court investors with the promise of higher returns than if they had solely invested with guarantees of a higher repayment priority.
  • Investors are offered a higher interest rate throughout the term of the note in return for putting up funds for the note. This is because if the company fails, these investors must wait until all other debt is repaid. In a worst-case scenario, they actually risk never getting their investment repaid.

Unsubordinated Debt vs. Subordinated Debt

The traditional structure of capital owned by companies exists in three categories: unsubordinated debt, subordinated debt, and equity. Both unsubordinated and subordinated debt involves the issuance of a promissory note that promises a fixed rate of return throughout the repayment of principal and interest. The difference lies in the risk, which of course exists with any type of investment.

That’s why sophisticated investors, who know how to conduct thorough research, typically make both types of investment. The old adage, “if it looks too good to be true, it probably is,” definitely applies to investing in a company’s debit.

Unsubordinated Debt

Unsubordinated debt, also known as senior debt, receives a higher priority than subordinated debit. This means that it is in what is termed a “first-lien” position, and the investment is recovered even if the company declares bankruptcy. It is a less risky form of investment because investors get first crack at any funds the company may still be holding or from money raised off the sale of equipment, property, and other assets.

Subordinated Debt

Borrowers of subordinated debt tend to be large corporations that have the capital to make riskier investments and an expertise in analyzing debt situations in the companies in which they typically invest. They are willing to gamble that the business will remain profitable throughout the term of the subordinate promissory note, and as a result, they will make more money than if they had invested with more strings attached.

Debt Featuring Convertibility Features

Sometimes a company offers to provide repayment of the debt in the form of common or preferred shares in the company. These features can be offered in either substantiated or unsubstantiated promissory notes, and the main characteristics of these agreements is the conversion price and the conversion ratio at which they are negotiated. Conversion price is, as the name implies, the price per share at which debt is converted in shares. On the other hand, the conversion ratio determines how many shares will be converted based on the amount of the debt and the price per share at which the shares will be purchased.

By adding a convertibility feature into the terms of the note, the investment opportunity adds a further element of potential benefit for both parties:

  • For investors, a subordinated convertible promissory note provides an opportunity to amass shares in a profitable company that could not be obtained through a stock offering. However, if the company does not perform well and its stock lowers in value, the investor will receive stock at no less than par value.
  • For the company, subordinated convertible promissory notes allow it to raise subordinated debt while limiting interest payouts because of the payout in shares instead.

A subordinated promissory note offers companies a relatively risk-free way to attract investment from parties looking for a large return on their investment. With the added incentive of making the promissory note convertible, companies can lower the risk for their investors while increasing their own rewards even further.

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