What is a 'Note'
A note is a financial security that generally has a longer term than a bill but a shorter term than a bond. U.S. Treasury notes, for example, are sold in $100 increments, pay interest in six-month intervals and pay investors face value upon maturity. There are numerous types of notes, including mortgage-backed notes, unsecured notes, municipal notes, bank notes, euro notes, promissory notes, demand notes and structured notes.
BREAKING DOWN 'Note'
An unsecured note is corporate debt without attached collateral, typically lasting three to 10 years. The interest rate, face value, maturity and other terms vary. For example, say Company A plans to buy Company B for $20 million. Since Company A has $2 million in cash, it issues $18 million in unsecured notes. Because no collateral is attached to the notes, if the acquisition does not work out and Company A stops making payments, investors may have little compensation if Company A is liquidated. Since an unsecured note is simply backed by a promise to pay, it has a higher interest rate and is riskier than a secured note or a debenture, which is backed by an insurance policy in case the borrower defaults on the loan.
A promissory note is written documentation of money loaned or owed from one party to another. The loan’s terms, repayment schedule, interest rate and payment information are included in the note. The borrower, or maker, signs the note and gives it to the lender, or payee, as proof of the repayment agreement. “Pay to the order of” is often used in promissory notes, designating to whom the loan is repaid. The lender may choose to have the payments go to himself or to a third party to whom money is owed. For example, Sarah borrows money from Paul in June and lends money to Scott with a promissory note in July. Sarah designates Scott’s payments go to Paul until Sarah’s loan from Paul is paid in full.
A convertible note is typically used by an angel investor funding a business without a clear company valuation. An early-stage investor may choose to avoid placing a value on the company to affect the terms under which later investors buy into the business. A convertible note is structured as a loan. The balance automatically converts to equity under terms governed by terms set when a later investor buys equity in the company. For example, an angel investor invests $100,000 in a company using a convertible note. An equity investor invests $1 million for 10% of the company’s shares. The angel investor’s note converts to one-tenth of the equity investor’s claim. The angel investor may receive additional shares to compensate for the extra risk of being an earlier investor.