What is a Note
A note is a legal document that serves as an IOU from a borrower to a creditor. Notes typically obligate the issuer to repay its creditor the principal loan and any interest payments on a predetermined date.
BREAKING DOWN Note
A note is a debt security obligating repayment of a loan at a set interest rate in a defined time period. There are numerous types of notes, including Treasury notes, mortgage-backed notes, unsecured notes, municipal notes, bank notes, euro notes, promissory notes, demand notes, convertible notes, and structured notes. Some of the most common notes are explained below:
The Treasury note, or T-note, is a financial security that generally has a longer term than a Treasury bill but a shorter term than a Treasury bond. The T-note is issued by the U.S. government when it wants to raise money to fund its debts or undertake new projects for the benefit of the economy. The notes are sold in $100 increments, pay interest in six-month intervals, and pay investors the full face value of the note upon maturity.
An unsecured note is a 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 to bond investors. Because no collateral is attached to the notes, if the acquisition does not work out and Company A defaults on its 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 issuer, 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 in July with a promissory note. 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. Under the termed conditions of a convertible note, the balance automatically converts to equity when an investor later 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.