What does subordination mean in a convertible bridge note?

May 8, 2007

In the event of default, creditors with subordinated debt don’t get paid until after holders of senior debt are paid in full. Startup companies may ask holders of convertible bridge notes to subordinate their debt to existing and future senior debt from banks and other lenders. (Of course, most seed stage startup companies are unlikely to be credit worthy enough for this type of debt, so subordination provisions may be irrelevant for many startups.) Subordination provisions provide the company with the flexibility to incur senior debt without going back to the holders of notes for consent. However, many banks will request that their own form of subordination agreement be signed by holders of notes instead of relying upon the subordination provisions contained in a typical convertible note. A subordinated convertible note will define types of senior indebtedness and sometimes will place a cap on the maximum amount of senior indebtedness that may be incurred by a company.

Traditionally, equipment leasing facilities and equipment loan facilities, which are secured solely by the equipment financed, are not treated as senior indebtedness (nor are they typically subordinated to other forms of a company’s indebtedness). However in certain circumstances, this type of financing may be deemed to be senior indebtedness (i.e., if secured by a blanket lien).