Understanding Senior vs. Junior Debt and Secured vs. Unsecured Debt

Does Senior vs. Junior Debt become a topic of conversation at your events? If your business hopes to take out multiple loans, you might be hearing the terms “senior secured debt,” “senior unsecured debt,” “subordinated (or junior) secured debt,” and “subordinated unsecured debt” for the first time. These terms classify your loans into various categories, and the terminology exists in order to sort out what would happen in the event your company can’t make the required payments on a loan or if your organization declares bankruptcy or faces liquidation. If this happens, the classification of your loans determines which debts are to be paid off first in the event you default (meaning you are unable to pay back your loans). Your loans and their classifications are what’s known as your organization’s capital structure.

How Loan Classification Affects Your Lenders’ Claims on Your Cash

In the event you default and file for bankruptcy, the matter gets sent to court, where officials determine the order in which your debtors will be repaid. Your debtors are repaid out of your assets, which are liquidated (turned into cash) during the bankruptcy process. There may not be enough money to pay everyone back. In this event, your senior debts will get paid, but your junior debts might not.

Essentially, if you default on your loans, the creditors who issued you subordinated debt won’t be paid anything until the lenders who own senior debt are paid in full.

Senior Debt vs. Junior (Subordinated) Debt

Senior debt is issued by lenders who take out first liens on your pledged assets, meaning they have first claim to your cash flows. To ensure your company stays solvent (able to repay its debts) senior debtors will often prevent you from taking out too much junior debt by establishing what’s called a senior debt convenant with you at the issuing of your senior loan. If you fail to follow the terms of the covenant, the senior debtor may be entitled to immediate loan repayment. Obviously, you can only take out so much senior debt, as each of your fixed assets can have only one first lien. Senior debt is often available as term debt or revolving credit. It’s offered by many major banks but is often be harder to get, especially for young businesses without many assets.

Junior debt is issued by smaller community banks, parent companies, and major shareholders. It offers business owners access to capital they might not be able to get from a large bank because the businesses don’t have enough tangible assets to use as collateral. Because lenders are receiving higher interest rates for junior debts, they may be more willing to extend this type of debt to younger organizations. In exchange for receiving high interest payments, junior debtors take on more risk, since they may not be repaid in the event of borrower default.

Secured Debt vs. Unsecured Debt

Senior debt is often, but not always, secured debt. Secured debt gets its security from an asset that you put up as collateral. So, you might pledge a vehicle or building your own outright in exchange for receiving a secured loan. Secured loans are a safe bet for lenders because, if you default, the asset is simply liquidated (sold for cash) and the lender gets its money back. Because this kind of debt is lower-risk, it also has a lower rate of return, so you’ll pay lower interest rates on senior secured loans than subordinated unsecured debts.

Unsecured debt is not backed by an asset pledged as collateral. If you have this type of debt and become unable to repay your loans, your unsecured debtors have to file repayment claims against your business’ general assets. Because this kind of debt is risky for lenders, they can charge higher interest rates than secured debt lenders. Junior debt is often unsecured; however, lenders may take second liens on your fixed assets in order to extend you junior (or subordinated) secured debt.

Bankruptcy Pecking Order

As you might have guessed, senior secured debt has the highest repayment priority in the event of bankruptcy. Then, senior unsecured debt is paid off from your general assets. If there’s anything left, your junior debtors will be repaid (with junior secured debt being repaid first, then junior unsecured debt) until either all the assets are exhausted or the debts are paid in full. As we mentioned earlier, junior loans are often not repaid in full in the event of bankruptcy, which is why they can justify charging higher (sometimes considerably so) interest rates.

In any case, all debtors are to be paid back before stockholders in the event of a bankruptcy or liquidation. If major shareholders issue junior debt, they are repaid just before stockholders.

Why Does Your Capital Structure Matter to You?

To be a responsible borrower and avoid becoming overleveraged or insolvent, it’s critical that you understand the types of debt you’re taking on, the covenants you’re agreeing to, the repayment schedules you must adhere to. When you understand how debt is classified, this can help you plan how to best pledge your collateral, which types of debt to pay off first and when or whether it’s realistic to attempt debt refinancing.

If you hope to attract investors, you should know that they’ll carefully scrutinize your debts and how they are classed (which is, as discussed, what’s known as your company’s capital structure), which enables them to determine how risky it is to invest in your organization.

Have Questions About Your Company’s Capital Structure?

Clearly, understanding your company’s capital structure, including its senior debt, junior debt, secured debt, and unsecured debt, is critical to the financial well-being of your organization. By understanding the types of debts you’re incurring, you can make more strategic borrowing decisions and best position your organization for long-term success and solvency.

Have more questions about debt classification? Want to discuss your organization’s current capital structure? Need to take out a new commercial loan? We can help! Rather than rushing you through the process, we put a great deal of energy into understanding your organization. This way, we can custom-design a loan that ensures the most favorable outcome for you—and the future of your business. Give us a call today to ask us any questions you might have or to start the application process on your business loan.