What Is a Note?

A note is a legal document that serves as an IOU from a borrower to a creditor or to an investor. Notes typically obligate issuers to repay creditor the principal loan, in addition to any interest payments, at a predetermined date.

Understanding Notes

A note is a debt security obligating repayment of a loan, at a pre-determined interest rate, within a defined time frame. There are numerous types of notes, including the following:

Issuers of unsecured notes are not subject to stock market requirements that force them to publicly avail information affecting the price or value of the investment.

Treasury Notes

Treasury notes, commonly referred to as T-notes, are financial securities that generally have longer terms than Treasury bills, but shorter terms than Treasury bonds. T-notes are issued by the U.S. government when it aims to generate funds to pay down debts, undertake new projects, or improve infrastructure, for the benefit of the nation and the overall economy. The notes, which are sold in $100 increments, pay interest in six-month intervals and pay investors the full face value of the note, upon maturity.

Unsecured Note

An unsecured note is a corporate debt instrument without any attached collateral, typically lasting three to 10 years. The interest rate, face value, maturity, and other terms vary from one unsecured note to another. For example, let's say Company A plans to buy Company B for a $20 million price tag. Let's further assume that Company A already has $2 million in cash, therefore it issues the $18 million balance in unsecured notes, to bond investors.

However, since there is no collateral attached to the notes, if the acquisition fails to work out as planned, Company A may default on its payments, in which case investors may receive little or no compensation, if Company A is ultimately liquidated.

Simply stated, an unsecured note is merely backed by a promise to pay, which makes it more speculative and riskier than other types of bond investments. Consequently, unsecured notes offer higher interest rates than secured notes or debentures, which are backed by insurance policies, in case the borrower defaults on the loan.

Promissory Note

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 issuer, signs the note and gives it to the lender, or payee, as proof of the repayment agreement.

The term "pay to the order of" is often used in promissory notes, designating the party to whom the loan shall be repaid. The lender may choose to have the payments go to his or herself or to a third party to whom money is owed. For example, let's say Sarah borrows money from Paul in June, then lends money to Scott in July, along with a promissory note. Sarah designates that Scott’s payments go to Paul until Sarah’s loan from Paul is paid in full.

Key Takeaways

  • A note is a legal document that memorializes a loan made from an issuer to a creditor, or to an investor.
  • Notes typically contain the terms in which the creditor is paid back, including the time frame in which the transaction concludes.
  • Notes entail the payback of the principal amount loaned, as well as any pre-determined interest payments.
  • The U.S. government issues Treasury notes (T-notes), in an effort to raise money to pay for infrastructure.

Convertible Note

A convertible note is typically used by angel investors funding a business that does not have a clear company valuation. An early-stage investor may choose to avoid placing a value on the company, in order to affect the terms under which later investors buy into the business.

Under the termed conditions of a convertible note, which is structured as a loan, the balance automatically converts to equity when an investor later buys shares in the company. For example, an angel investor may invest $100,000 in a company, using a convertible note, and an equity investor may invest $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 added risk of being an earlier investor.