What does subordination mean in a convertible note?
Takeaway: The subordination clause in a convertible note is a standard and non-controversial term that makes the note junior to any future "real" bank debt, a protection that senior lenders require before they will provide a loan to your company.
As you review the terms of your convertible note agreement, you will encounter a section on subordination. Because a convertible note is a debt instrument, it has a "priority" in the company's capital structure—a ranking that determines who gets paid back first in the event of a bankruptcy or liquidation. The subordination clause defines this priority.
In a startup convertible note, the subordination clause is standard and straightforward: it states that the convertible notes are subordinate to all of the company's future "senior indebtedness." This is a key term, but it is not something founders typically need to negotiate.
What is Senior Indebtedness?
"Senior indebtedness" refers to "real" debt from a traditional lending institution (real in the sense that the intent is that it gets repaid rather than converted into equity). This most commonly means a loan from a bank or a venture debt facility. It does not refer to other convertible notes or standard trade payables (like the money you owe your vendors).
How Subordination Works
The subordination clause is essentially a promise from your noteholders to any future senior lender. It says, "In the event of a liquidation, we agree to let you, the senior lender, get paid back in full before we receive a single dollar."
Why is this necessary? No bank or venture debt provider will lend money to a startup unless they are in the first position to be repaid. They need to know that their loan is senior to all other debt on the balance sheet. The subordination clause provides this assurance.
Is this bad for the noteholders? Not really. Your convertible note investors are not acting like traditional lenders. They are not expecting to be repaid in cash; they are expecting their notes to convert into equity. Their real return will come from the appreciation of their stock, not from the priority of their debt. They understand that for the company to grow and raise the capital it needs (including debt financing), their notes must be subordinate.
A Standard and Expected Term
The subordination clause is a standard, boilerplate provision in every well-drafted convertible note. It is not a point of contention and is accepted by all sophisticated angel investors and seed funds. While it's important to understand what it means, you should not view it as a negative term. It is a necessary piece of legal architecture that allows your company to have the flexibility to take on traditional debt financing in the future, which can be a critical tool for funding your growth without additional equity dilution.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.