Chapter 7 – Types of Debt
Most companies carry some form of debt. Being able to recognize the different types of debt can allow a new entrepreneur to better manage and source money.
The Four Types of Debt:
- Senior debt is debt that is owed to one entity before all others. Typically, an agreement is made between a company and a debtor that this particular debtor has been granted “exclusive rights” to being paid before anyone else. To build on this, if a company was to go under, the entity that holds senior debt will be paid first and in-full before anyone else is paid. Senior debt is granted by request of the lender, however, if asking for more sources of investment…other entities may refuse to invest if they know senior debt has been granted to someone else. So take your time and think about your needs before granting senior debt.
- Subordinated debt, also known as sub debt or mezzanine debt, is debt that is owed to other entities after senior debt. Sub debt is usually more expensive than senior debt, and for good reason. If you are unable to repay your debt, the senior debt holder is guaranteed to get recuperated, while subordinate debtors are not. Therefore, the cost of this debt is higher to make sure sub-debtors, at least, make their money back (or as close to it as they can get).
- Short-term debt is debt that is due within 12 months. There are two forms: revolver (for working capital) and current maturity of long-term debt. Short-term debt is typically used to finance smaller items such as replenishing inventory or finance daily operations. Senior and Sub debt can also be included in short-term debt if the debt is to be repaid in the given timeframe.
- Long-term debt is debt that is amortized for a time frame over 12 months. Senior and Sub debt can also be included in long-term debt if the debt is to be repaid in the given timeframe.
One of the biggest advantages to using debt as a way to finance operations is that you get to retain ownership of your company. This is a big deal if you don’t want to give equity away, just to place an order for materials to get ready for the holidays. You know the money will be coming in, so just use debt to get the capital required to meet demand. There are also tax benefits to making payments on a business loan!
Rogers, Steven. Entrepreneurial Finance: Finance and Business Strategies for the Serious Entrepreneur – Third Edition. McGraw Hill, 2014.