Subordination agreements are a component of the business industry that refers to the profess of using debt to finance business operations. Subordination agreements allow companies to take on more debt than they otherwise could and in times of trouble, it can allow a company to continue operating without getting their bank loans called in by the bank. Whether subordination agreements are good or bad often depend on which side of the agreement you find yourself and how well the company is performing.
The first scenario where subordination agreements can be employed is when a company is bought or sold. Quite often, the group buying the company does not have enough money to buy the company outright. The buyers pool what money they have and then go to a bank to apply for a commercial loan for the balance of what they need. Sometimes, the bank will not feel comfortable lending the amount of money needed with the only equity being what the buyers are willing to put in.
What Happens When Buyers Have No More Money
Now, if the buyers don’t have any more money, they have three options. They can walk away from the deal, they can try to negotiate with the seller to lower the price, or they can try to get the seller to agree to fund part of the buyout price himself. So instead of the bank providing a term loan that has to be repaid over a set number of years, the seller of the company agrees to be paid the balance of the sales price over a set number of years.
The way the seller’s note becomes subordinated is when the buyer goes back to the bank and informs them that the seller agreed to finance part of the buyout by accepting a note payable from the buyers. Banks always wants to be paid first. They don’t want to compete with anyone else for a company’s cash flow. So, when the potential buyer comes back to the bank requesting that the bank funds the buy out, the bank might demand that the seller sign a formal subordination agreement that basically says that the bank will be paid first.
Forms of Subordination Agreements
That subordination agreement can take many forms. The bank can demand that the seller’s note not be repaid until the loan the bank is providing is paid off, they can demand that the seller only be paid interest on his note until the bank loan is paid off, or whatever sort of variation that gives the bank priority to the company’s cash flow. The seller doesn’t have to agree to the subordination agreement but he risks not being able to sell the company to the buyer due to the buyer’s lack of money.
Poor performance can also lead to debt becoming subordinated. In this case, an owner or prior owner might have made a loan to the company to either assist with a buyout or to provide operating funds. At the time the loan was made, the company might have been doing well enough that the bank did not feel the need to subordinate the debt. As time passes and performance deteriorates, the bank might begin to feel nervous about being repaid and want to tighten up the company’s credit structure. To improve their position, the bank might demand that the owner formally subordinate the money he was owed by the company to the bank. Again, the owner is not obligated to do so but they run the risk of having his financing pulled by the bank. If the company’s performance is trending down, the owner will have a difficult time finding a new source of funding so more often than not, a subordination agreement will be generated. Doing so allows the company to continue operating and provides the opportunity to turn things around.