What does subordination mean in a convertible note?
Takeaway: Subordination comes into play when the company has multiple sources of debt (usually a bank loan). It means that if the company defaults on its bank loan or the notes, the bank loan gets repaid before the notes. If there is not enough money to repay the bank loan in full, the notes will not get repaid.
Convertible promissory notes are a popular financing option for startups, offering a balance of flexibility and potential returns for both founders and investors. When a startup already has debt outstanding (particularly bank debt), it will sometimes have to subordinate the new convertible promissory notes to the existing debt. In this post, we will explore what subordination means in the context of convertible promissory notes, how it affects the repayment hierarchy, and the implications for startups and investors.
Subordination: Definition and Purpose
Subordination refers to the process of assigning a lower priority to a specific debt or lender in the event of the borrower's default or bankruptcy. In the context of convertible promissory notes, subordination typically involves an agreement between the startup and the note holder to prioritize other debts over the repayment of the convertible note.
The primary purpose of subordination in a convertible promissory note is to maintain an existing lender’s priority on the assets of the startup, enhance the startup's creditworthiness and facilitate additional borrowing. When borrowing from banks, startups will often be required to agree that they will subordinate all debt to the bank’s debt. By subordinating the convertible note, a startup can also demonstrate to potential future lenders that their debt will be prioritized over the note holder's claim, making it more likely for the startup to secure additional financing. In practice, any future lenders are likely to require that the convertible notes be subordinated to the new bank debt.
Implications for Startups and Investors
Subordination in convertible promissory notes can have significant implications for both startups and investors:
For Startups: Subordination can be beneficial for startups, as it allows them to access additional financing by prioritizing new lenders' claims over existing convertible note holders. This can help startups secure the funds needed for growth and development. However, it's essential to carefully consider the terms and conditions of subordination, as it may increase the complexity of the startup's capital structure and create potential conflicts with existing investors.
For Investors: For investors holding a subordinated convertible promissory note, the primary risk is that their claim on the startup's assets and cash flow will be ranked below that of other lenders in the event of default or bankruptcy. This may result in delayed or reduced repayments and could negatively impact the investor's return on investment. Despite these risks, subordination may still be acceptable to some investors if they believe in the long-term potential of the startup and anticipate the note's eventual conversion into equity.
Negotiating Subordination Terms
Startups may not always have very much room to negotiate subordination provisions - banks often require that all other debts be subordinate to them in basically all circumstances. However, the specific terms and conditions of subordination in a convertible promissory note can vary depending on the negotiation between the startup and the investor. Key aspects to consider when negotiating subordination terms include:
Ranking of Debts: The subordination agreement should clearly outline the priority of debts in the event of default or bankruptcy. This includes specifying which debts will be prioritized over the convertible note.
Conditions for Subordination: The agreement should define the circumstances under which subordination will be triggered, such as the startup securing additional financing or achieving specific milestones.
Rights and Remedies: The subordination agreement should outline the rights and remedies available to the investor in the event of default or bankruptcy, including any limitations on their ability to enforce their claim.
Conclusion
Subordination agreements in convertible promissory notes involve complex legal considerations and should be drafted with the guidance of experienced legal counsel. Ensuring compliance with applicable laws and regulations is essential to protect the interests of both the startup and the investors.