This guide explains what senior debt is and why it is used. It also explains the types of senior debt that companies often use as well as the risk of senior debt compared to other financing options.
To understand why a company would use senior debt, we have to understand why it would want to use any type of debt in the first place. Debt is used as a form of financing, and generally, a business has two sources of raising outside capital for financing purposes: debt and equity.
If a business needs money for growth and it doesn’t have the ability to pay the necessary expansion costs for that growth out of its cashflow, it can look to raise money with either debt or equity. Simply put, equity is an ownership stake and debt is borrowed money to be repaid as per the agreement.
The ultimate purpose of using either debt or equity to raise capital is to maximize the value of the business while balancing profitability and risk. In short—they want money to grow the business and understand that taking outside capital has costs and risks associated with it. They weigh these costs and risks against the potential upside when making the decision to borrow money or not.
Generally, debt is grouped into two categories: senior debt and subordinated debt. This guide focuses on senior debt, specifically.
Generally, senior debt refers to term loans and to revolver debt.
Two of the most common types of revolver debt are credit cards and revolving lines of credit. Revolving lines of credit are lines of credit that give the borrower constant access up to the limit of the line of credit. So, if a company has a revolving line of credit of $100,000, then they have consistent access to that $100,000 and they pay interest on only the amount they have borrowed. So, if the company uses $9,000 of that $100,000 line of credit to pay a supplier, it only owes interest on the $9,000 (until it is paid back). Revolving lines of credit are valuable because the business doesn’t need to apply and go through the approval process every time they need smaller amounts of money. They can use a revolving line of credit as needed for financing purposes. To learn more about revolving lines of credit, read of guide: Revolver Debt: Lines of Credit.
Term loans are another common type of senior debt. Unlike revolving lines of credit, term loans have a fixed schedule of repayment. Term loans can be structured in different ways. Some common ways include amortized payments, balloon payments, and bullet payments.
In exchange for lending the lump sum of money to the borrower (called the principal), the lender gets interest. How the term loan is structured determines how the lender will be paid their interest. Some term loans involve quarterly payments of interest and principal, and other loans may require only interest payments made for a period of time, with a final repayment of the principle at the end of the loan. Term loans can also be “stacked,” meaning that a business can have more than one term loan at a time. To learn more about term loans read this guide.
As stated above, the ultimate purpose of using either equity or debt to raise capital is to maximize the value of a business while balancing profitability and risk.
This section looks at the risk of senior debt.
Debt and equity have different costs and risks associated with them. For equity, the major cost is that ownership is diluted whenever equity is given away. If the founder owns 100 percent of their business and wants to raise money in exchange for equity, they end up owning 75 percent if they need to give away 25 percent to acquire the money they need.
Senior debt has the advantage of not diluting the existing ownership stake. This comes at the cost of paying the interest expense on the money they borrow. There is also risk inherent in debt that isn’t a risk with equity. If a business can’t repay the debt, then the lender will call in the loan and the business may need to file for bankruptcy if it can’t meet its debt obligations.
Senior debt is the least risky type of debt, because lenders who provide senior debt to businesses have the highest claim to the business’ cash flow. In other words, they get paid before others.
Generally, senior debt is priced at the lowest interest rate compared to other debt instruments. So, the reduced risk to the investor gives them less profit from the lower interest rates they earn on the loan. To lenders issuing senior debt this lower profit is weighed against the fact that if the business were to default on the loan (not be able to pay), they would be paid back before other investors would.