Starting up a business takes a lot of things: time, patience, determination, experience, hard work, and vision-to name a few. However there is one factor that stands above all others when starting a business, which acts as a barrier for entrepreneurs everywhere: money. The expenses for a new business (or buying an existing business) are usually staggering. Everything has a cost: from real estate, to equipment, to just keeping the lights on. For most business-owners-to-be, a loan-or several loans-are in order to make their dreams a reality. Usually from venture capitalists or banks, these initial lenders usually have collateral (such as the business's property or assets such as equipment) and are the first to be repaid. This debt is known as senior debt.
Senior Debt vs. Junior Debt
Senior debt has nothing to do with age and everything to do with seniority: that is the order in which the debt must be repaid. Normally these loans are the initial and largest investments in the company, with a lien-the right of the debtor to keep possession of property until debt owed by that person is discharged. Junior debt-holders must wait until senior debt-holders are paid and do not have the security of collateral.
Senior Debt as a Business Owner
If you take out a loan from a bank or other lending institute, you probably owe them senior debt. These have all the conventional bonuses of a loan from the bank: a fixed repayment plan and relatively low interest rate. However, since you are putting up something significant as collateral (usually the property and equipment for which you took out the loan) it means that if you are unable to pay this debt that you stand to lose the property you put in lien to these creditors.
Senior Debt as a Lender
Senior debt is considered a low-risk form of lending for two reasons. First, if the business fails, the senior debt must be paid first. Second, if the company cannot pay out to these debtors, the collateral assets can be sold off to pay towards the debt. However, due to its low risk as a form of financing, it is also low-return: the lender gains a fixed amount of money (usually on an amortization schedule) with a low interest rate.
Senior Debt Compared to Mezzanine Loans
There are generally three forms of lending. In repayment order they are: senior debt, mezzanine loans, and equity. While senior debt has collateral against the loan in form of physical assets, a mezzanine loan (also known as mezzanine financing) instead has a collateral of an ownership stake or equity interest of part of the company. Mezzanine carries higher risk due to little actual collateral and due diligence, and therefore carries higher interest. Since mezzanine loans are taken out against the perceived value of ownership these loans are usually only available to a company with an existing reputation and good standing. To learn more about mezzanine loans and how they can benefit your company, read this article.
George & Company are experts in the field of business, for over 30 years providing services in mergers, acquisitions, valuations, financing, and franchising for businesses both big and small. If you're looking to get into the industry by buying a business, or if you need some guidance about what has worked for the business we've helped by and sell, please contact us.