Startup Capital: Senior vs Subordinated vs Venture Debt

In the world of startup financing, finding the right capital mix is paramount to fostering growth within an organization. Among the various funding options, debt stands as one of the more popular, since it’s pretty straightforward to qualify for, the cost of capital is relatively low, and it's fairly flexible. Given you’re reading this guide, we’re going to assume that you’re in the process of evaluating the various debt options available to your startup—if that's the case you’ve come to the right place. In this guide, we shed light on the differences between senior and subordinated debt, the ideal use cases and the associated risks of each, and more. Let’s dive in!

Senior debt: a deep dive

At its core, senior debt represents the highest-ranking obligation in a startup's capital stack. Investors who provide senior debt hold a priority claim over the company's assets and cash flows in case of default or bankruptcy. These range from tangible assets like inventory and equipment to intangible assets like intellectual property (e.g. negative pledge on IP).  Lenders use these assets as a safety net, allowing them to recover their investment in case the startup defaults on its repayment obligations. Thanks to their “senior” status, they are first in line to be repaid before other creditors.

As such, these debt providers will often provide larger facilities and charge lower interest rates, compared to the alternatives. Also, the repayment terms for senior debt tend to be more structured and predictable, which is helpful for cash flow management. The most common forms of senior debt include revolving credit facilities and term loans.

Unpacking subordinated debt in startup funding

In contrast to senior debt, subordinated debt takes a low position in the capital stack. In the event of a default, these lenders get paid back after the senior debt holders, and as such have a higher risk profile. This results in higher interest rates and smaller sizing. It also typically means that the structure of the deal is more flexible and so are the payment terms, which can be beneficial for startups who have dynamic cash flows.

Subordinated debt often finds its place in startups that are willing to take on calculated risks for the sake of growth. This type of debt can be particularly suitable for startups with strong growth potential but limited collateral or assets to offer. Subordinated debt can be particularly beneficial for startups with cyclical cash flows, as they can align the repayment schedule with their revenue cycles.

Quick comparison of senior vs subordinated debt

The choice between senior and subordinated debt largely boils down to priorities. Senior debt emphasizes security and stability, offering lower interest rates and priority repayment in exchange for stricter collateral requirements. Subordinated debt, on the other hand, appeals to startups seeking greater flexibility, albeit at the cost of higher interest rates and lower repayment priority. Ultimately, both forms of capital have their place and should be considered when optimizing your capital stack.

Risk-return tradeoff: how each debt type impacts startup growth

As mentioned above, senior debt comes with lower interest rates and longer repayment terms, which can alleviate immediate financial burdens, allowing startups to allocate resources to growth initiatives. Due to its longer-term nature, it can also be used to invest in initiatives that will not drive short-term revenue such as R&D or product development. Subordinated debt on the other hand typically has a shorter repayment period and higher interest rates, and should not be used for activities that will not generate short-term revenue growth. Typically subordinated debt is reserved for sales hires and marketing campaigns.

Flexibility and control: debating debt structures

The choice between senior and subordinated debt often extends beyond the financial considerations into a startup’s aspirations, appetite for risk, desired flexibility, and stage.

• Aspirations - Startups that are participating in highly competitive markets, and need to achieve rapid growth are better suited for subordinated debt, than startups that are focused on steady, sustainable growth. This is because the subordinated debt facilities can be deployed and paid back quickly, leading to increased sizing, and so on. Since senior debt is typically tied to the startup’s assets, not revenue, which do not grow as quickly, the sizing remains relatively stagnant.
• Risk appetite - Senior debt's priority repayment status aligns best with startups that have a conservative appetite for risk. For startups with a greater appetite for risk, subordinated debt is a better option because it allows them more room to experiment, adapt, and potentially achieve exponential growth. 
• Investor expectations -  Startup debt decisions often intersect with investor expectations. Investors' preferences and risk tolerance, like the founders’, can influence startups’ debt choices. Some investors might prefer the stability of senior debt, while others might be open to subordinated debt if they believe it's in the best interest of the startup. Venture debt is one of the most often recommended forms of debt financing by investors. For more information, check out the startup founders' guide to venture debt in 2023.
• Flexibility - Senior debt offers a higher level of control over your startup's operations by virtue of its priority repayment status. Subordinated debt on the other hand introduces an element of flexibility that can be invaluable in the event of unexpected opportunities or rapidly changing market conditions. 
• Stage - early stage startups have dynamic business models which result in frequent pivoting, as such they are more suited for subordinated debt. More established startups with stable and mature revenue streams are better suited for senior debt, which provides stability and a lower overall cost of capital.

Where venture debt fits in senior vs subordinated debt

Generally speaking, venture debt is considered senior debt, due to the associated covenants, clauses, and provisions with most deals. These terms can result in lenders having priority claims over a startup's assets, collateral, and even IP. That said, in some cases, venture debt is subordinated to a revolving credit facility or other term loan that takes the priority position. For a more in-depth look, check out the startup founders’ guide to raising venture debt in 2024.

The senior and subordinated debt-raising & decision-making process

The debt-raising and decision-making process is relatively straightforward. Once you understand how much capital you need and what providers fit your criteria, then you’ll negotiate term sheets and access the capital. We’ve included a greater breakdown of the steps below.

Step 1: Assess Financial Needs and Goals
Begin the debt decision-making process by evaluating your startup's financial needs and goals. How much capital do you require? What are your growth objectives? What are your headcount plans? This assessment will lay the foundation for choosing the right debt structure (senior vs subordinated).

Step 2: Evaluate Risk Tolerance and Business Stability
As mentioned, subordinated debt might be suitable if you're comfortable with higher risks for potentially greater rewards or if you operate in a dynamic market. Conversely, if you're risk-averse and prioritize stability, senior debt might align better with your business's financial profile. Ultimately, you’ll want to make sure that the executive team is comfortable with the risk profile of the capital you’re pursuing.

Step 3: Craft a Customized Debt Strategy & Identify Debt Providers
Based on the insights gained from the previous steps, craft a customized debt strategy. This strategy should align with your startup's financial needs, risk profile, and growth ambitions. Remember that debt decisions are not one-size-fits-all – tailor your approach to your unique circumstances. Then create a list of all the potential debt providers that meet your needs, whether senior or subordinated.

Step 4: Apply for Debt & Receive Term Sheets 
After you’ve identified your target debt providers, complete the application process. Immediately following this, make sure you complete a deep dive on your financials—you’ll want to understand your current revenue, revenue mix, revenue growth rate, revenue concentration, burn, runway..etc. Hopefully, you’ll land a handful of meetings, which will result in at least two term sheets.

Step 5: Negotiate The Terms 
The final step in the debt-raising process is negotiating the term sheets. Most founders focus on the interest rate, payment period, and overall structure of the deal, while those certainly are important, what’s more important, is the covenants or associated provisions. These can seriously impact your day-to-day operations, so you’ll want to completely understand what you’re agreeing to before signing the term sheet.

Step 6: Backchanneling
This is an optional step.If you are connected to other founders who have raised from the providers you are considering working with, ask about their experience. Was the lender available for questions & consultation? Was the lender understanding if the startup faced hardship? Was the lender flexible with the sizing of the facility, adjusting when the startup grew? These are all questions you’ll want answers to.

Mitigating risks associated with senior, subordinated and venture debt

There are three main actions you can take to mitigate the risks associated with senior or subordinated debt, we have outlined them below. 

• Preemptive measures - Startup debt comes with inherent risks. Implementing preemptive measures, such as rigorous financial planning, stress testing, and contingency plans, can mitigate the likelihood of default and financial distress. We suggest building a 25-30% buffer for all of the models that you create to account for changes in the market environment.
• Restructuring and refinancing options - If your startup faces financial challenges, restructuring, and refinancing may be the only options. They can help you renegotiate terms, extend repayment schedules, or even consolidate debt to regain financial stability. Not all providers will offer restructuring or refinancing options, which is why it’s crucial to backchannel and select a partner that acts in your best interests.
• Prioritize stability - Startup debt decisions should always prioritize long-term sustainability. Periods of rapid growth fueled by related capital injections upon milestone completion are normal. Periods of rapid growth from a business with negative unit economics, and a dependency on consistent capital injections in a contracting macroeconomic environment (e.g. 2022 and 2023) is a recipe for disaster. By managing cash flows, operating sustainably, and maintaining transparent communication with creditors, you can ensure that your startup remains resilient even in the face of financial challenges.

Closing thoughts: striking the right balance

The decision between senior and subordinated debt isn't about picking one over the other. Instead, it's about crafting a balance that aligns with your startup's unique circumstances and growth trajectory. Striking this balance requires a deep understanding of your startup's goals, your risk tolerance, and the financial landscape in which you operate.

It's worth noting that this decision isn't set in stone. As your startup matures, you might find that your debt structure needs to evolve as well. Whether you opt for senior debt's stability or subordinated debt's flexibility, the key is to be intentional, well-informed, and adaptable in your approach.

In the end, your choice of debt structure will shape your startup's financial journey. So take the appropriate amount of time to evaluate your choices, negotiate the terms, and backchannel the providers to ensure that you’ve selected the right partner.

We’re by no means legal professionals, and this guide by no means legal advice, but if you’d like an extra set of eyes (or hands) reviewing your term sheets, or if you’d like introductions to senior or subordinated debt providers, we’d be happy to help out. Get in touch with us!

Happy Building!