My current banker is only charging me prime +1% on our operating credit and prime + 3% on our equipment financing - why does sub-debt cost P+ 8% to 12%?

This is much like comparing apples and oranges. Operating credits and equipment financing are examples of secured financing - meaning that there is an asset (either accounts receivable or equipment) supporting the financing. If the company is in distress then the secured lender can exercise their security, collect the firm's receivables and/or liquidate the equipment in order to recover their loans. As such the senior lender's downside risk is limited and pricing can be low.

Subordinated debt is just that - subordinated to the senior lender's position - and therefore a sub-debt lender is unable to recover any of its investment in a distress situation. For this reason, unsecured financing needs to command a higher price so that successful financings offset the relatively larger losses a sub-debt lender faces on 'less successful' investments.

Furthermore, a senior lender will generally not provide unsecured loans so if a firm does not have collateral to pledge then the only alternative to sub-debt is equity and most any institutional equity investor will need a return of 30% to 40% to get them interested.

One thing that we make very clear when meeting with prospective clients is that we charge more solely because there is no collateral security supporting our debt. The higher rate is by no means a reflection on the quality of the business - in fact we only deal with businesses that are exceptional from a management and operational perspective, are usually growing rapidly, and are generating strong cashflow - the cream of the crop!

When considering sub-debt financing there are two key questions to ask oneself:

1. Is this the least expensive form of financing that is available to the company given the lack of tangible assets available to pledge as security?
2. Can the company get 'leverage' from the financing - ie. can it generate a greater return on the funds than what is being charged by the sub-debt lender?

If the answer to both questions is yes then sub-debt is probably a good choice for your company.

What will my existing banker say?

Generally, because sub-debt is subordinated to your existing lender's position, this financing serves to improve the senior lenders security position. For example let's say we lend a company $500,000 which they use to develop a marketing program to increase sales. The increased sales create a higher level of accounts receivables which, in turn, improves the margining on the operating credit being provided by the senior lender.

Additionally, many senior lenders will consider sub-debt as equity for the purpose of their debt/equity covenants. Sub-debt lenders may provide stand-down agreements which confirm that if the company does not meet certain performance measures (cashflow coverage, debt/equity, working capital ratios, etc.) the sub-debt lender will postpone principal draws and even capitalize interest if necessary. Because sub-debt can act like equity if it has to it can be treated as equity for the purpose of the senior lender's debt/equity calculations. This is an important factor as it serves to keep the company in covenant and can pave the way for additional senior lender support.

The only time a senior lender may express concern about a company considering a sub-debt investment is if the existing lender is not confident that the company can support the additional debt servicing requirements. If the company can't demonstrate a clear ability to support additional debt then sub-debt lenders are unlikely to consider financing them in the first place. Furthermore, we discuss proposed sub-debt investments with the applicant's existing banker (and accountant) to ensure that all parties are agreed that the investment is the best course of action for the business.

Can I prepay the loan at any time without penalty?

Generally sub-debt investments are subject to a significant prepayment penalty. The reason for this stems from the fact that we are talking about an unsecured portfolio. Sub-debt lenders take a significant risk when extending financing to support a company's growth initiatives and if every firm that prospers as a result of the investment pre-pays without penalty then our portfolio would consist only of the companies that were not performing as expected. Needless to say the portfolio wouldn't be around for long.