Entrepreneurial Finance, Third Edition: Finance and Business Strategies for the Serious Entrepreneur by Steven Rogers & Roza E. Makonnen

Author:Steven Rogers & Roza E. Makonnen [Rogers, Steven]
Language: eng
Format: azw3
Publisher: McGraw-Hill Education
Published: 2014-04-17T16:00:00+00:00

TYPES OF DEBT

There are basically four types of debt: senior, subordinated (sometimes called sub debt), short-term, and long-term. The first two refer to the order of entitlement or preference that the lender has against the debt recipient. Holders of senior debt have top priority over all other debt and equity providers. The senior holders are the “secured creditors,” who have an agreement that they are to be paid before any other creditors. If the company is dissolved, the senior holders are entitled to be paid first and “made whole” as much as possible by selling the company’s assets. After the holders of senior debt have been completely repaid, the remaining assets, if there are any, can go to the providers of subordinated debt.

A lender does not automatically get the senior position simply because it made the first loan. The lender must request this position, and all other present and future lenders must approve it. This can sometimes be a problem because some lenders may refuse to subordinate their loan to any others. If the other lenders will not acquiesce, then the loan is generally not made.

Sub debt, also referred to as mezzanine debt, is subordinated to senior debt, but ranks higher than equity financing. The term mezzanine comes from a reference to the design of theaters, where there are often three levels, with the middle level being called the mezzanine. Both types of debt are used for financing working capital, capital expenditures, and acquisitions. Mezzanine financing usually occurs after senior lenders exhaust their lending capabilities. Finally, because it is in a subordinate position, mezzanine debt is typically more expensive than senior debt.

Mezzanine and senior debt, in addition to equity, constitute a company’s capital structure, which describes how the company finances itself. Therefore, when a company’s capital structure is said to be highly leveraged, this means that it has a large amount of long-term debt.

Debt that is amortized over a period longer than 12 months is considered long-term debt (LTD). It can be senior or mezzanine. It is found in the balance sheet in the long-term liabilities section. Loans for real estate and equipment are usually multiyear, long-term debt obligations.

In contrast, short-term debt (STD) is that which is due within the next 12 months. STD comes in two forms: revolver debt, which is used for working capital, and current maturity of long-term debt. It is found in the balance sheet in the current liabilities section. This debt typically has a higher cost than does long-term debt. Short-term debt is usually used to buy inventory and to fund day-to-day operating needs.

Let’s look at the strengths and weaknesses of debt financing.

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