Junior debt, also popularly known as subordinated debt or subordinated financing, is a deficit type with a lesser priority in the debt and debt repayment pyramid. It’s usually unprotected and might be given without security, making it precarious. That’s why the interest rates on junior debt funding are often greater than those on senior debt.
Subordinated debt is unlikely to be serviced if a business goes bankrupt, as senior debt obligations will take precedence. The term “subordinate” refers to the debt suppliers’ status in terms of priority.
Liquidators, national tax authorities, and senior debt are ranked higher than the junior debt obligation.
It is supposed to be settled after all other financial commitments to senior debt providers and creditors have been paid or met.
The Basics of Junior Debt Funding
Consider the following scenario to understand better how subordinated debt works:
Lately, XYZ Corporation has chosen to issue bonds. Bondholders would be involved in the transaction.
The bondholder is a creditor of XYZ corporation, and because bondholders are deemed to have precedence over shareholders, bondholders will be paid first on the payback list if XYZ Corporation goes out of business.
Let’s imagine XYZ Corporation learns they need more money.
The company obtains a loan from Bank CDE, which is classified as junior debt funding due to the terms and conditions agreed upon by the bank and the company.
In the event that XYZ Corporation declares bankruptcy, bondholders will still be paid first, followed by Bank, CDE, and then the shareholders.
Because unsubordinated debt is riskier than other debt and hence issued with a higher interest rate- the higher interest rate compensates for the debt’s inherent risk.
Subordinated debt is frequently uncollateralized, and the principal amount is typically only returned when the company sees long-term growth. Mezzanine debt is another term for junior debt.
Subordinated Debt Usages
As part of debt securitization, junior debt can be utilized to issue collateralized mortgage obligations, collateralized debt obligations (CDO), or asset-backed securities.
Although firms avoid junior debt because of the exorbitant interest rates, it is preferable to dilution of present ownership through the issuance of new public shares. Subordinated debt can also be used to fund recapitalization, acquisitions, and growth capital, among other things.
Junior Debt Reporting in Financial Data
Subordinated debt funding is recorded and reported on a company’s Statement of Financial Position, just like other obligations (Balance Sheet).
After senior debt, it is reported as long-term debt in the liabilities section (i.e., senior debt is recorded first).
Long-term obligations are normally recorded in order of priority on the Statement of Financial Position in the event of liquidation.
Preference for Liquidation
One of the most important financial principles in venture capital investing is liquidation preference.
The phrase expresses investors’ and/or other stakeholders’ (debt-related) preferences for dividend payments and other debt repayments. Liquidation preference assures that particular shareholder and/or loan sources be paid before other stakeholders.