One of the most difficult issues to overcome when seeking capital is the existence of a previous lien holder. This means your company has already borrowed against some business assets and is now looking for more capital. When a company secures capital from a debt finance lender, there is always collateral involved. The lender will file a UCC-1 with the State agency where the company incorporated. This in effect limits the company from borrowing any additional capital.
There are rare situations where a company might find a lender who will subordinate parts of the collateral in order to gain access to more working capital. Examples of this might be an equipment leasing company subordinating the accounts receivables to a factoring company. Or you may have a bank who has a small line of credit to a company seeking more capital. The bank is not interested in offering any additional capital, but could work with a secondary lender by subordinating some of the collateral. In these cases a subordination agreement or intercreditor agreement will be created to protect both lenders who have an interest in the same clients’ collateral.
The huge obstacle to overcome is the legal language that both lenders will need to agree to in order for it to work. Each lender will have legal counsel who will attempt to have a one sided agreement leaving the other lender at risk. Usually the senior lender who is being asked to subordinate has little incentive to do so, which gives very little room to negotiate.
The ramifications of subordination are complex and far reaching. It may seem straight forward but the possibilities of all parties ending up in a snarling protracted legal quagmire are boundless. Usually there has to be just the right mix of incentives for all parties to reach an agreement.
One other situation where a subordination agreement frequently comes up is with the Internal Revenue Service. When a company fails to pay their taxes the IRS will be in contact to about getting the payments current. Failure to comply with their correspondence means eventually they will file a lien on the company assets. In order for a finance company to come along to start providing badly needed working capital the IRS will have to subordinate the collateral to the lender. Actually this is easier to obtain provided there is a payment plan in place and the tax payer is adhering to the plan by making timely payments. The IRS sees the need to allow the company to gain access to working capital in order for them to get repayment of back unpaid taxes.
Overall, subordination agreements are tricky by nature and hard to come by – but they are a necessary legal tool for companies using commercial finance.