SUBORDINATION: Protect Junior Debt on Business Sale
Corporate Buy-out - Selling Shares - Forced to Sell - Buying out Shareholders - Buying into a Company
Contact Neufeld Legal PC at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com
The subordination of junior debt is a financial arrangement whereby junior debt (subordinated debt) is agreed to rank below other debts (senior debt) in terms of repayment priority. This means that in the event of a company's liquidation, bankruptcy, or default, the holders of the junior debt will only receive repayment after all senior debt obligations have been fully satisfied. Because this debt carries a higher risk, junior debt typically has a higher interest rate than senior debt.
When selling your business, the use of subordinated debt is a common feature in the purchase arrangement, wherein the seller agrees to provide a portion of the financing to the buyer, through the financing mechanisms of a promissory note or vendor take-back arrangement (VTB). The buyer's primary lender (e.g., a bank) will almost always require the seller's promissory note or vendor take-back loan to be subordinated to their senior loan.
If the seller agrees to take junior debt (a promissory note or vendor take-back loan) that is subordinated to the buyer's senior financing, the seller become a creditor of the newly acquired business and is exposed to the risk of non-payment. Strategies to facilitate a degree of protection of the seller's subordinated debt should include:
A. Thoroughly Vet the Buyer and the Deal
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Buyer Due Diligence: Go beyond the offer price. Investigate the buyer's financial strength, management experience in the industry, and credit record. A well-capitalized buyer with a proven track record is the best mitigation against default.
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Significant Down Payment: Negotiate for the largest possible cash down payment at closing. This reduces your risk exposure and ensures the buyer has meaningful equity invested in the business.
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Limit Subordination: Seek to limit the principal amount and interest rate of the senior debt to which your note is subordinated. This prevents the buyer from taking on excessive senior debt that could erode the business's ability to repay you.
B. Secure Your Repayment
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Personal Guarantees: Obtain a personal guarantee from the buyer's principals (owners and their spouses, if possible). This ties the buyer's personal assets to the repayment obligation, creating a recovery path if the business defaults.
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Security Interest: Formalize a security agreement with the buyer and file a lien against the assets of the business. While this lien will be subordinate to the senior lender's, it puts you ahead of unsecured creditors (like trade payables) in case of liquidation.
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Promissory Note and Covenants: Ensure the Seller Note (promissory note) includes strong protective provisions:
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Acceleration Clause: A clause that makes the entire unpaid balance immediately due if the buyer misses a payment or breaches a key covenant.
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Protective Covenants: Restrictions on the buyer's actions that could diminish the business's value, such as limitations on executive compensation, dividends/distributions to the new owners, and the sale of assets outside the ordinary course of business.
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C. Negotiate the Subordination Agreement
The subordination agreement is a contract between you (the seller/junior lender), the buyer, and the senior lender. This document is critical:
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Default Triggers (Standstill Period): Negotiate with the senior lender for specific terms on when they can prevent the buyer from paying you (the seller). You'll want to avoid automatic payment blocks for minor or technical defaults on the senior debt.
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Information Rights: Require the buyer to provide you with regular financial statements so you have advance warning if the business is running into financial trouble.
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Right to Cure: Negotiate a right to step into the buyer's shoes and cure a default on the senior debt if the buyer fails to do so. This can protect the business's value and your subordinate note.
D. Consider Alternatives
If the buyer's financing structure is too risky, you may explore:
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Third-Party Financing for the Buyer: Encourage the buyer to seek out the full purchase price from other sources, such as third-party lenders, so you receive your full payment at closing.
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Earn-Out Structure: Instead of a subordinated note, structure a portion of the payment as an Earn-Out, where you receive future payments based on the business's actual performance (e.g., hitting EBITDA targets). This is equity-like risk, but not debt, and often avoids subordination issues.
For knowledgeable and experienced legal representation in undertaking business acquisitions, or facilitating the sale of your current business, contact corporate business lawyer Christopher Neufeld at Chris@NeufeldLegal.com or 403-400-4092 / 905-616-8864.
