Subordination Agreements – Creation, Impact, and Termination

In the startup environment, financing models such as convertible loans or shareholder loans are common. While essential for growth, such financing can significantly burden the balance sheet and lead to formal over-indebtedness. A properly structured subordination agreement under Art. 725b para. 4 item 1 of the Swiss Code of Obligations (CO) provides important legal leeway in such situations.

What is a subordination agreement – and when is it appropriate?

A subordination agreement is a contractual arrangement in which a creditor agrees to subordinate their claim behind all other creditors and only demand repayment if doing so does not result in over-indebtedness. It is considered a contract in favor of third parties (Art. 112 CO) and serves two main purposes:

• Protection of other creditors
• Preservation of the company’s ability to restructure and continue operations

Special case: Convertible loans

Convertible loans are treated as liabilities until conversion. Despite their equity-like characteristics, they burden the balance sheet and may lead to over-indebtedness in early-stage companies. A carefully structured subordination of convertible loans offers several benefits:

• Temporary legal neutralization of repayment obligations
• Preservation of going concern status
• Flexibility to convert into equity at a later stage

Termination of a subordination agreement – only under strict conditions

A subordination agreement must be concluded for an indefinite period. Termination is not automatic and is only permissible when all of the following conditions are met:

1. Audited balance sheet: The balance sheet must be audited by the statutory auditor in accordance with applicable Swiss auditing standards.
2. Full coverage of liabilities: The audited balance sheet must clearly demonstrate that all liabilities – including subordinated claims – are fully covered by the company's assets.
3. Type of audit matters:
• For ordinary audits, a summary audit report without a reference to Art. 725 CO is sufficient.
• For limited audits, a separate audit report with positive assurance is required, since the standard report provides only negative assurance in accordance with Art. 729b CO.

The subordination agreement must be drafted with these audit requirements in mind. It may only be lifted contractually once all listed conditions are demonstrably met.

Practical notes

• No partial repayments: While the subordination is in effect, no repayment or offsetting of the subordinated claim is permitted.
• Foreign currency claims: If the claim is denominated in a foreign currency, the subordination should be established in the same currency.

Debt waiver vs. subordination: A debt waiver permanently extinguishes the claim and results in a true balance sheet restructuring. In contrast, a subordination merely suspends enforceability – the claim continues to exist.

Conclusion for founders and investors

A properly structured subordination agreement creates legal certainty for all stakeholders – particularly during the critical phase between seed financing and market breakthrough. For investors using convertible loans, subordination is a strategic tool to support the startup without immediately demanding repayment – under clearly defined legal conditions.

We are here to support you with the legally sound drafting, audit review, reduction and termination of subordination agreements.