What Are Senior Notes?

Written by

Meow Advisory, LLC

Published on

Monday, January 8, 2024

What Are Senior Notes?

Senior notes, also referred to as senior debt, are a form of debt financing that gives the lenders priority claim to assets and cash flows in the event of default or bankruptcy. Unlike other debt instruments like subordinated notes or junior debt, senior notes are deemed less risky for lenders due to their senior status.

Some key features of senior notes include:

  • Priority repayment - Senior lenders get paid back before other creditors and equity holders in case of liquidation. This offers them greater safety.
  • Fixed interest rates - Most senior notes carry a fixed coupon rate that does not fluctuate over the tenor of the loan. This allows the borrower to have better cash flow visibility.
  • Collateralization - Senior notes are often backed by company assets, providing lenders with more security. The pledged assets can be seized and liquidated if the borrower defaults.

Types of Senior Debt

There are a few common types of senior debt instruments:

  • Senior Unsecured Notes - These notes do not have any collateral backing them up. Lenders take on higher default risk with these notes in exchange for potentially higher interest rates. Unsecured senior notes depend completely on the borrower's creditworthiness.
  • Senior Secured Notes - These notes, also called senior secured debt, provide lenders with a senior claim on certain company assets that are pledged as collateral. This makes secured senior notes less risky for lenders. Banks and other financial institutions often issue such notes.
  • Senior Secured Private Debt - Many private lenders issue custom senior debt with warrants to startups and growth-stage companies. These notes bridge financing needs before equity dilution. Terms are based on factors like revenue, margins, and cash flows.

Qualifications for Senior Debt Financing

Senior loans have more stringent requirements than other startup financing options. Some typical qualifications include:

  • Recent equity round - Lenders want to see a recent equity financing round by a reputed VC/PE fund before considering senior debt. This signals the startup's growth potential.
  • Financial performance - A track record of rising revenues, predictable cash flows, and improving financial ratios is important to demonstrate creditworthiness.
  • Repayment history - Startups need to show on-time repayments for any existing loans to secure senior loans for additional funding.
  • Collateral - Hard assets to pledge as security are often required to lower the lender's risk when issuing senior debt.
  • Personal guarantee - Founders may have to personally guarantee some senior loans, making their personal assets liable in case of a default.

Uses of Senior Debt for Startups

High-growth startups can use senior lending facilities to:

  • Finance growth by investing in production capacity, warehousing, technology etc.
  • Support acquisitions of competitor firms or companies within the supply chain
  • Refinance other high-interest debt that is squeezing margins
  • Fund R&D initiatives to build proprietary technology, algorithms, patents etc.
  • Purchase essential equipment, machinery, and office spaces

Benefits of Senior Debt Financing

Some main advantages of opting for senior debt include:

  • Senior loans provide quick access to growth capital without diluting founder equity or requiring a higher valuation.
  • Interest rates on senior debt are fixed rather than variable, providing better visibility into financing costs.
  • Financing terms can extend to 5 or more years, suitable for long-term growth needs. By contrast, junior debt has shorter 2-3 year terms.
  • Unlike mezzanine or equity financing, senior loans do not require giving up stake in the startup.

Drawbacks of Senior Debt Financing

A few downsides to raising senior debt exist as well:

  • Interest costs tend to be higher than for mezzanine and equity financing. Only get senior loans if confident of maintaining cash flows.
  • They may require pledge of tangible assets as collateral, leaving less unencumbered assets. Other forms of startup financing do not require collateral security.
  • Loan covenants can impose operating restrictions in terms of leverage ceilings, covering fixed charge obligations, etc. This leads to loss of financial flexibility.
  • In case of default, senior lenders get paid back before anyone else. Founders and investors see lower liquidation value from assets.
  • If servicing debt becomes difficult, lenders can recall the outstanding loan, leading to possible insolvency and bankruptcy.

Conclusion and Key Takeaways

Senior debt is suitable for later stage, high-growth startups that need capital for expansion without further dilution. It has priority claims over assets and cash flows compared to other financing types. Key characteristics like fixed interest rates, longer tenors and non-dilutive nature make senior loans worthwhile despite having restrictive covenants. By offering collateral security and strong financials, startups can unlock growth capital quickly from senior lenders.

Learn More about Venture Debt

To Learn more about Venture Debt you can read our free guide for Beginner's here: https://www.meow.com/venture-debt-guide

This free guide to Venture Debt walks through key terms, what to consider when raising venture debt and a list of lenders to get started with.

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