The scenario is simple: a company is requesting a performance and payment bond or maybe a bonding program. The surety feels that the company’s net worth is insufficient to support the surety bond program or specific job that needs bonding. A subordination agreement can solve a net worth deficiency in some cases.
Why is Net Worth Important to the Surety?
“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, net worth or stockholders equity is typically comprised of the money initially put in to start the company paid in capital, plus all the net profits earned over its lifetime, or retained earnings.
Sometimes the underwriters may believe that the net worth of the company is insufficient to support the current bonding needs. Obviously the problem cannot be fixed by instantly earning more net profits. It could possibly be addressed by adding additional capital stock, however it is possible that this would be heavily taxed (capital gains) upon withdrawal. Especially if the increased need for net worth is viewed as temporary, subordinated debt maybe a viable option.
Here’s how it works:
The owner, or someone close to the owner, makes a long term loan to the company.
There is a promissory note drawn up and the note can pay interest to the lender.
Normally, a loan would be considered a liability and not help the net worth of the company at all. However, if the lender is willing to execute a subordination agreement, the surety company may consider this loan as “quasi” equity or net worth.
A subordination agreement is executed by the lender, the company that receives the loan, and the surety. It’s basically an agreement that the loan cannot and will not be paid back without the consent of the surety. The purpose of the subordination agreement is to make the loaned funds just as valuable as capital by making the loan “permanent” for the purposes of the surety.
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.
Not all surety companies allow subordinated debt. A surety bond only agency, staffed by long time surety personnel, can will know which companies will allow subordinated debt.