Subordinated Debt in a Family Business

It is an old, old story in the family business world. A parent and a child start a business together. Or two siblings start a business together. Or a parent starts a business and passes it to her several children.

However you get there, you end up with a business owned and run by multiple family members. For a while, the synergies, energy and bonds between the family members are what fuels the business. It is what makes it succeed when another, similar business might not.

But after some time, one or another of the family members wants to go in a different direction. Sometimes there is a falling out. Other times, circumstances just change. In any event, everyone agrees that one of the family members should exit the business.

But a minority interest in a closely-held business is a very illiquid asset. There is just no open market to sell it. Maybe one or more of the other family members is ready and willing to buy out the exiting family member, but it is unlikely they have the cash available to do so.

Moreover, frequently trying to structure this sort of an exit with a loan from one family member to another only compounds whatever the problem was that led to the family member wanting to exit. And the bank is probably not interested in funding the purchase – its interest is with the business and the assets and earnings of the business.

Why Consider Subordinated Debt?

It is not uncommon for a business to have some form of bank debt. This is sometimes referred to as “senior debt” because the bank usually takes a first priority security interest in the assets of the business and establishes itself with the right to be paid back before anyone else in the business can get paid.

Subordinated debt is money borrowed – usually from a lending institution other than a typical, commercial bank – that sits behind the senior debt, usually in both its rights to any of the assets of the business and in its rights to repayment.

Because the investment is riskier for anyone making this kind of a loan, the interest rates tend to be a bit higher than traditional bank debt.

Reasons Why Subordinated Debt Makes Sense for Family Businesses

Subordinated or “mezzanine debt” has been around in one form or another for several decades, but it is only in the last decade or so that it has really become an option in the family business circumstance described above. In the last decade or so, several things have changed to make this possible.

First, as this form of lending has proven to provide real returns against the risk, more and more subordinated debt lenders have cropped up. This means there are now enough options in the market that it is an accessible and appropriately priced option.

Second, subordinated debt providers are more and more willing to work with smaller companies. Historically, subordinated or mezzanine debt was something you would only find at much larger companies with much more complicated capital structures. But now there are any number of national and regional providers that actually focus on the “lower middle market.”

Finally, the providers of subordinated debt have come to understand that it does not only have to be used in the acquisition of a business. Historically, mezzanine debt would only find its place when someone was purchasing a business and the amount of cash they could provide, along with the bank financing they could get, was not enough.

In these circumstances, the buyer would seek out subordinated debt to be able to bridge that financing gap. But now, companies and subordinated debt lenders are understanding that this is a useful financing tool for any number of pivotal moments in a business’ life cycle.

Subordinated Debt Can Help Pave the Way for an Amicable Split from the Family Business

In the family-owned business described above, where one of the family members wants to exit, but the remainder want to continue to run and grow the business, acquiring subordinated debt should be considered as a solution. It means more debt on the business (and debt with higher interest rates), and many family-owned businesses have strong feelings about taking on debt.

But if the business can manage to service the subordinated debt, it is an efficient, non-dilutive way for the business to get the funds to allow that family member to exit easily and without dispute.