Secrets of Bonding #20: Subordination Agreements

“Instant Net Worth!”

Here is another gem for your tool box.  A Subordination Agreement can solve a Net Worth deficiency problem easily – in some cases.

Why is Net Worth (NW) Important?

Net Worth is the value of the company if all its bills are paid and it is liquidated.  It is a measure of strength and staying power, and therefore is relevant to surety bond underwriters.

In a corporation, NW (aka Stockholders Equity) is typically comprised of the money initially put in to start the company (Capital Stock) plus all the net profits earned over its lifetime and retained in the company.

Sometimes the NW is insufficient to support the current bonding needs.  This problem cannot be fixed by instantly earning more net profits.  It could be addressed by adding additional capital stock, but this is heavily taxed (capital gains) upon withdrawal – so this may not be a good solution, especially if the need is viewed as temporary.  So in comes our Subordination Agreement.

Here’s how it works:

Let’s assume that an owner who originally put money into the company by purchasing capital stock has now loaned funds to the corporation.  Both are debts of the company. Here is the important difference: Capital Stock is considered Equity, and a permanent debt (because of the tax penalty assessed upon withdrawal) whereas a loan is called a Liability and is temporary since it may have periodic payback terms and there is no capital gains tax assessed.

When making bonding decisions, does an underwriter consider loaned money as valuable as capital stock?  Is money the company has temporarily as valuable as funds it holds permanently? No, of course not. The purpose of the Subordination Agreement is to make the loaned funds just as valuable, by allowing them to be viewed as permanent.  From an analysis viewpoint, this moves the loaned money from debt to equity.

The Subordination Agreement is executed by the creditor (lender of the money) for the benefit of the Surety.  It states that the creditor will not demand payment without the written consent of the surety in advance. It locks the money in.  Having this degree of control can allow a surety to treat the subordinated loan as Instant Net Worth!

Two words of caution:

  • Not all sureties are willing to rely on this strategy or may not do so for a major portion of the total NW.  Check with your underwriter.
  • Also, it is important to inform the CPA regarding the subordination so it can be memorialized in the financial statement notes.  The subordination only works if the creditor remembers to observe it.

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