What is Subdebt Financing and when should you consider it?
Subdebt is high yielding debt that is subordinated to the senior secured debt of a business but ranks ahead of the shareholders’ equity. Subdebt lenders rely upon the ability of a business to generate sufficient cash flows to service both the senior secured debt and their subdebt.
The annual cost of subdebt (after-tax cost of 8% to 12%) is higher than senior secured debt (after-tax cost of 3% to 5%) but less than the cost of equity (after-tax cost of 15% to 25% for private companies). Alternative financing typically considered in lieu of subdebt include vendor-take back financing for an acquisition and/or asset based financing which provide larger operating lines and term lenders/leasing alternatives which lend on the value of the assets of the business.
Subdebt financing offers the following advantages: it enables growth initiatives, acquisitions and management buyouts to be implemented; it maximizes the availability of debt at the lowest cost of capital for the business; it enables shareholders to minimize their equity investment thereby minimizing their business risk; it provides access to debt financing on the intangible assets of the business; and, it enables the maximum return on equity investment of the shareolders of the business to be achieved.
Case Illustration
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ABC Co. (“ABC” or the “Company”) is a well established business with a management team with a proven track record in place.
ABC's senior management team has entered into management buyout (MBO) negotiations to acquire the shares of the founder of the Company for $6.5 million. ABC’s senior debt capacity was fully utilized and the Company’s management team had $3 million in equity available to invest into the management buyout. ABC's management team and its trusted advisors undertook to raise $3.5 million in subdebt to fund the balance of the agreed upon purchase price ($6.5 million minus $3 million).
ABC's balance sheet and income statement and selected financial statistics/ratios are presented under two alternatives: 100% of the $6.5 million purchase price financed with equity; and, $3.5 million of the $6.5 million purchase price financed with subdebt and the remainder of the purchase price of $3 million financed with the equity available from the management team. Raising subdebt enabled the management team to undertake the management buyout with the limited $3 million in equity available. In addition, the subdebt alternative enabled the return on equity to be increased to 34.4% versus 22.9% had the purchase price been financed 100% with equity (assuming $6.5 million in equity had been available from the management team).
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Claude Conan, CA, CPA, CBV, MBA (Founder and President of Quantum Advisory Inc.) can be reached by telephone at 780.669.9724 or email at claude.conan@quantumadvisory.ca.