Financing Products: Subordinated Debt

The Situation:

Image the following scenario.

Your company has performed well for many years but has recently identified an opportunity to pivot into a new line of business (or “LOB”) by buying a competitor. This new LOB is complimentary to your existing products and services and is generating good net profits. Once acquired, you are confident that you and your management team will be able to reduce expenses and grow sales over the next 24 to 36 months.

As a founder, you are faced with the tough decision of:

a) finding a way to finance the acquisition itself, while

b) having enough cash on hand to support the ongoing working capital needs of the new LOB, without

c) diverting too much cash flow away from the existing business.

The Solution:

From a financing product perspective, subordinated debt (or “sub debt”) might be the ideal solution in this scenario. The table below compares and contrasts the key features of senior and sub debt.

In terms of the scenario we outlined above, one of the main selling features of this product in an acquisition scenario is the ability to defer a portion of the principal payments to the end of the loan term. This allows much needed cash generated by your business to be put to work in the business today vs. repaying debt.

The Risk:

The risk, for both you the borrower as well as the lender, is that the bulk of the loan repayment resides at the tail-end of the loan term. Therefore, it is crucial that your company hit its revenue and profit targets such that the business has enough cash in the bank on the maturity of the sub debt loan to either a) repay the bullet in its entirety or, b) provide the financial strength to refinance (or roll-over) the remaining bullet into a traditional term facility.

The structural risk and lien rank of the sub debt lender, as noted above, it mitigated through higher pricing, various restrictive covenants and special features.

If you are thinking about raising capital in order to make an acquisition, buy out a partner, or sell a portion of your company to one or more of your employees, sub debt might be an option to finance the transaction. Please send me an email to trevor.palmquist@kaeroscapital.com and I’d be happy to explore some options with you. 

Cheers, Trevor

Founder & Managing Director