Key Takeaways

  • A subordinated promissory note is a debt instrument that ranks lower in repayment priority than other debts in case of default.
  • These notes appeal to companies for their flexible fundraising benefits and to investors for their potential high returns.
  • Subordinated promissory notes often include convertible features, allowing debt to be exchanged for equity under specific conditions.
  • Clear documentation, including interest terms, maturity, and payment schedule, is essential to enforceability.
  • Promissory notes—subordinated or otherwise—can be secured or unsecured and must comply with state and federal laws.

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.

Key Components of a Promissory Note

Every promissory note—whether subordinated or senior—should include specific components to ensure it is legally enforceable and clearly understood by both borrower and lender. These elements typically include:

  • Principal Amount: The total sum the borrower promises to repay.
  • Interest Rate: The agreed-upon rate, which can be fixed or variable.
  • Maturity Date: The final due date for the entire repayment.
  • Payment Schedule: Whether payments are due monthly, quarterly, or in a lump sum.
  • Parties Involved: Full legal names and addresses of both borrower and lender.
  • Default Terms: What constitutes default and the consequences (such as interest acceleration or collection action).
  • Subordination Clause: In subordinated notes, this outlines the priority structure in case of liquidation.
  • Governing Law: Indicates the jurisdiction whose laws apply to the agreement.

Having these items clearly defined in the note protects all parties and reduces disputes regarding obligations or enforcement.

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.

Secured vs. Unsecured Promissory Notes

Promissory notes can also be categorized based on whether they are backed by collateral:

  • Secured Promissory Notes involve collateral—like property, vehicles, or other assets—that the lender can claim if the borrower defaults. This adds a layer of protection for the lender, making the note less risky.
  • Unsecured Promissory Notes have no collateral backing. These rely entirely on the borrower’s creditworthiness and are riskier for the lender, especially if the note is also subordinated.

Subordinated promissory notes are often unsecured, compounding the risk. This is why lenders often demand higher interest rates in return.

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.

Common Use Cases for Promissory Notes

Promissory notes serve many practical purposes in both personal and commercial finance. Common use cases include:

  • Startup Financing: Founders often issue subordinated or convertible promissory notes to raise early-stage capital without immediately giving up equity.
  • Real Estate Transactions: Private lenders use promissory notes to formalize loan terms in real estate deals.
  • Intercompany Loans: Businesses within the same corporate group might use promissory notes to document internal funding.
  • Employee Loans: Companies that extend loans to employees may use a promissory note to record repayment terms.
  • Debt Consolidation or Refinancing: Individuals consolidating debt can issue a new promissory note to a single lender with new terms.

These use cases illustrate the flexibility of promissory notes, especially subordinated versions, in accommodating unique financing scenarios.

Legal Considerations and Enforceability

Promissory notes are binding legal instruments, but their enforceability depends on compliance with contract law. Important legal considerations include:

  • State-Specific Requirements: Some states require notarization or witness signatures for enforceability.
  • Usury Laws: Interest rates must comply with state usury laws to avoid penalties or voiding the note.
  • Integration Clauses: Including a clause that the note represents the complete agreement helps prevent disputes over outside terms.
  • Remedies on Default: Clearly define acceleration clauses, late fees, and other remedies in case of nonpayment.

To enhance enforceability, promissory notes should be drafted or reviewed by legal professionals, especially when subordination or conversion rights are involved.

Frequently Asked Questions

  1. What is the promissory note definition?
    A promissory note is a legally binding document in which one party promises in writing to repay a debt to another party under agreed terms.
  2. What makes a promissory note subordinated?
    Subordinated notes rank lower in repayment priority than other debts. In a liquidation or bankruptcy, senior creditors are repaid first.
  3. Is a subordinated promissory note riskier for investors?
    Yes, it carries higher risk since repayment is not guaranteed if senior debts exhaust the borrower's assets. However, it typically offers higher returns.
  4. Can a subordinated promissory note be secured?
    It can be, but it's uncommon. Most subordinated notes are unsecured, relying on the borrower's overall financial strength and future prospects.
  5. What happens if a borrower defaults on a promissory note?
    The lender may take legal action to recover the debt, including claiming collateral (if secured), accelerating repayment, or seeking court enforcement.

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