Small and medium enterprises (SMEs) often encounter unique challenges in securing funding. Traditional loans can be restrictive and difficult to obtain, especially for businesses without an extensive credit history or substantial collateral. That’s where subordinated debt emerges as a viable alternative.
This flexible financial instrument is often misunderstood and underutilized but offers several benefits that can be particularly advantageous for SMEs.
What’s Subordinated Debt?
Subordinated debt, also known as “junior debt,” is a type of financing that ranks lower than other forms of debt in terms of claims on assets or earnings. It means that in the event of a company’s default or liquidation, subordinated debt is paid out after other forms of debt, hence the term “subordinated.”
Because of this lower priority in repayment and the increased risk involved, it’s considered riskier and, therefore, typically has a higher interest rate than other types of loans. Still, many investors, especially those comfortable with the additional risk, offer this financing because of its higher returns through high interest rates.
Here are the benefits of subordinated debt to SMEs:
Enhanced Borrowing Capacity
One of the most significant advantages of subordinated debt for SMEs is its ability to enhance borrowing capacity. When a company opts for subordinated debt, it can maintain its senior debt capacity for other uses. It’s because subordinated debt doesn’t usually count against the borrowing limits set by senior debt lenders.
As a result, SMEs can access more funding than they could through senior debt alone. They can then use this additional capital in scaling operations, investing in new projects, or bridging gaps in cash flow.
Flexibility in Terms and Repayment
Subordinated debt typically offers more flexible terms compared to traditional loans. Despite higher risks, subordinated debt lenders may be more willing to negotiate terms that align with the borrower’s needs.
This flexibility can be in various forms, such as longer repayment periods, interest-only payment options, or customized repayment schedules. It’s particularly beneficial for SMEs that often experience fluctuations in revenue and may need more accommodating repayment structures.
Preservation of Ownership and Control
Subordinated debt is better than equity financing. The latter is a method of fundraising by selling company shares to investors. In exchange for their investment, shareholders receive ownership interests in the company.
In contrast, subordinated debt allows business owners to secure financing without diluting their equity. It means that SMEs can retain full control over their company’s operations and decision-making processes. For many small business owners, maintaining this control and independence is critical to their long-term vision and growth strategy.
Tax Advantages
The interest payments on subordinated debt are tax-deductible, which means they reduce the taxable income of the SME. It can lead to significant tax savings for SMEs, especially those in higher tax brackets. For SMEs operating on thin margins, this deduction can also lower the overall cost of capital for the business.
Equity financing, on the other hand, doesn’t offer this tax advantage. Any dividend payments made to shareholders are made from the company’s after-tax income. In other words, they’re not tax-deductible.
It’s worth noting, however, that if a company’s value increases, shareholders may benefit from capital gains if they sell their shares at a higher price than they bought them. Still, these capital gains are typically taxable for the shareholders, not the company.
Strengthened Credit Profile
Successful management of subordinated debt can strengthen an SME’s credit profile over time. Taking on and responsibly servicing this type of debt can help it demonstrate its creditworthiness to future lenders.
It can be particularly valuable for SMEs building or repairing their credit histories. A stronger credit profile not only promotes sustained growth and financial stability but also opens doors to more favorable financing options in the future.
Potential Risks of Subordinated Debt for SMEs
While subordinated debt can be a powerful tool for growth, it’s not without risks, which SMEs should approach with due diligence. The primary risk associated with subordinated debt is its higher cost.
As mentioned, subordinated debt usually comes with higher interest rates than traditional loans. That’s because it’s riskier for lenders, given its lower repayment priority. For SMEs, this could impact their business’s cash flow and financial stability if not properly managed.
Another risk is its “covenants,” which are specific terms limiting certain business activities, like additional borrowing or asset sales. These can restrict an SME’s flexibility in terms of financial and operational decision-making and may impose certain limitations on the company’s ability to raise additional debt.
Lastly, the subordinated nature of this debt means that in the event of default or liquidation, subordinated debt holders are lower in the pecking order and are, therefore, more likely to incur losses. This riskier positioning could impact an SME’s ability to raise further capital because prospective lenders or investors may view the company as having a higher risk profile.
Final Thoughts
Subordinated debt can offer significant benefits for SMEs, such as increased borrowing capacity and flexibility in repayment terms. However, it’s crucial to carefully consider the higher interest rates, potential impact on cash flow, and increased overall debt burden.
Given the complexity and risks associated with this type of financing, SMEs are strongly advised to seek professional financial advice. It will ensure that subordinated debt aligns with their specific business needs and long-term financial strategy.
