A subordination agreement is a contract in which one creditor agrees to rank behind another, usually a senior lender. The junior creditor accepts that the senior loan is paid first, that its own lien, if it has one, comes second, and that it will stop taking payments and hold off on enforcement when the senior loan is in default. The borrower usually signs to acknowledge it. It is how a seller note, an owner's loan or a mezzanine loan fits beside bank debt. SBA's full standby is its strictest form: no payments at all for the life of the SBA loan.
- Parties
- Senior lender and junior creditor; the borrower acknowledges
- Common junior creditors
- Sellers, owners and shareholders, mezzanine lenders
- Key terms
- Permitted payments, payment blockage, standstill, turnover
- Strictest form
- Full standby: no principal or interest at all
- SBA version
- The Standby Creditor's Agreement (SBA Form 155)
Two kinds of subordination
"Subordinated" gets used for two different promises, and a single agreement often makes both.
- Payment subordination ranks the debt itself. The junior creditor agrees that the senior loan must be paid in full before it receives payment, at least when things go wrong. This applies whether or not the junior debt is secured. An unsecured seller note can be payment-subordinated.
- Lien subordination ranks claims on collateral. Where both creditors hold liens on the same assets, the junior creditor agrees that the senior lien comes first. The junior debt is still owed in full; it just waits in line for the collateral.
The difference shows up in a default. A creditor with only lien subordination can still be paid from sources other than the shared collateral. A creditor with payment subordination generally cannot be paid at all until the senior lender is. Senior lenders dealing with a seller or an owner almost always ask for both. Between two institutional secured lenders, the document is usually called an intercreditor agreement and focuses on liens and enforcement; see second lien loans.
The terms inside the agreement
Subordination agreements run from two pages to fifty. The length is in the detail, but the same handful of terms decides how the junior creditor is actually treated.
| Term | What it says | What the junior creditor negotiates |
|---|---|---|
| Permitted payments | Which scheduled payments the junior creditor may receive while no default exists | Whether principal is allowed or only interest; whether payments also need a covenant test to be met |
| Payment blockage | When the senior lender can stop payments to the junior creditor | Whether any senior default blocks payments or only a payment default; how long a block can last |
| Standstill | How long the junior creditor must wait before suing, accelerating or taking collateral | The length of the wait and what ends it |
| Turnover | Anything the junior creditor receives in breach must be handed to the senior lender | Rarely negotiable |
| Amendment limits | The junior creditor cannot raise its rate, shorten its maturity or add collateral without consent | Room to amend within limits |
| Senior debt cap | How much senior debt the junior creditor has agreed to rank behind | A cap, so the senior lender cannot lend more and push the junior creditor further back |
| Bankruptcy terms | How the junior creditor votes and what it may object to in an insolvency | Often left as the senior lender drafts them |
A blocked payment is usually not forgiven. It accrues, and once the default is cured, the junior creditor can often be caught up. Whether that catch-up is allowed, and whether default interest runs on the junior note while it is blocked, are worth settling in the agreement itself.
A worked example
Take a business with cash available for debt service of 150 in a year, a senior loan with payments of 100 and a subordinated seller note with payments of 40. While the business meets its covenants, the agreement permits both: the senior lender is paid 100, the seller 40, and 10 is left over.
Now say earnings fall and the business breaches its debt service coverage covenant. The senior lender sends a blockage notice. The seller's payments stop. If the owner pays the seller anyway, perhaps out of loyalty, the seller must turn the money over to the senior lender, and the owner has created a second default. The seller cannot sue on the note during the standstill. When the covenant is back in compliance, payments resume, and the missed ones are paid if the agreement allows a catch-up.
Paying a blocked junior creditor is not a kindness. It breaches the agreement, the money goes to the senior lender anyway, and the business is left in a worse default than before.
Subordination is not the same as SBA full standby
In an SBA-financed acquisition, the seller note is subordinated too, but SBA adds its own layer. For a start-up or a complete change of ownership, SBA requires an equity injection of at least 10% of total project costs. A seller note can count for up to half of that injection only if it is on full standby: no principal or interest payments for the life of the SBA loan. Interest may accrue and be paid after the SBA loan is repaid. The seller signs SBA's Standby Creditor's Agreement, Form 155, and the note's own terms must match.
A seller note that is not on standby is allowed, but it is debt. It counts in debt service, not toward the equity injection, and its payments must fit within the coverage the lender requires. Lenders will still want it subordinated, with the usual blockage and standstill terms.
| Ordinary subordination | SBA full standby | |
|---|---|---|
| Payments while the senior loan performs | Scheduled payments usually allowed | None, principal or interest |
| Payments after a senior default | Blocked | None |
| How long | Until the senior loan is repaid, but payments may run meanwhile | The life of the SBA loan |
| Counts toward SBA equity injection | No | Up to half of the required injection |
| In debt service coverage | Its payments count | Excluded, since nothing is paid |
| Document | The senior lender's form | SBA Form 155, plus the lender's own terms |
See seller notes and SBA's full-standby rule and the subordination terms a seller should expect.
Who is asked to subordinate
Any creditor a senior lender does not want competing for cash or collateral:
- Sellers who take back a note for part of the price. Outside SBA, how much a seller can be paid currently depends on coverage and leverage; see seller note terms in conventional deals.
- Owners and shareholders who have lent money to the business. Lenders usually require those loans to be subordinated and often block repayment entirely while the senior loan is outstanding; see how lenders treat shareholder loans.
- Mezzanine lenders, whose unsecured or junior-secured debt is subordinated by design; see mezzanine debt in the lower middle market.
- Related companies with intercompany balances, such as a property company owed rent or a sister company owed for shared services.
Subordination is contractual. It differs from structural subordination, which arises from which company in a group owes the debt, not from any agreement. Both decide who is paid first, and a lender will read both when it looks at the group.
The best time to agree subordination terms is in the letter of intent, before the seller or owner has fixed expectations about being paid. Transparent's lender package lays out every subordinated obligation, its payment terms and its effect on coverage alongside the loan request, so lenders price the structure rather than discover it. See what goes in the package.
Common questions
- Does subordinated mean the junior creditor never gets paid?
- No. Most subordination agreements let scheduled payments run while the senior loan is in good standing. Payments stop only if the senior loan defaults, and may resume once the default is cured. SBA full standby is the exception: nothing is paid for the life of the SBA loan.
- Who signs a subordination agreement?
- The senior lender and the junior creditor. The borrower usually signs to acknowledge it, because the agreement restricts what the borrower may pay.
- Can a subordinated seller note be paid on an SBA loan?
- Yes, if it is not counted toward the equity injection and the lender allows it. A paid seller note is debt and counts in debt service. Only a note on full standby for the life of the SBA loan can count for up to half of the required injection.
- What is a payment blockage period?
- The time during which the senior lender can stop payments to the junior creditor after a default. Agreements often block payments indefinitely after a payment default and for a limited period after other defaults. The length is negotiated.
- Is a subordination agreement the same as an intercreditor agreement?
- They overlap. A subordination agreement usually ranks the junior debt in payment, and is common for sellers and owners. An intercreditor agreement usually governs two secured lenders' liens, enforcement rights and collateral, and is common for second lien and split-lien structures.