What it means
A note is a formal debt instrument. It records the amount borrowed, the interest rate, the dates of payment and the maturity date, which is when the principal must be repaid.
When the note is unsecured, nothing in the document gives the lender a specific asset to fall back on. Companies issue unsecured notes to raise money from banks, private investors or the bond market.
They suit businesses with a strong record and steady cash flow, since a lender would not accept the risk otherwise. Smaller businesses sometimes issue them to family, friends or angel investors, who accept the higher risk in exchange for a higher rate.
The interest rate is set higher than for an equivalent secured note, and the gap is called a risk premium. Investors also look at the issuer's credit rating, its debt level and any covenants that limit risky behaviour.
Where an unsecured note is subordinated (ranked below other debts), the rate will be higher still. In the accounts, the issuer records the note as a liability, current if due within a year and long-term otherwise.
Interest accrues as an expense over the life of the note and is paid on the dates stated. If the note is repaid early, the issuer may owe a prepayment fee, depending on the terms.
If the issuer fails, noteholders rank alongside other unsecured creditors, behind any secured lenders. Because of this, investors often negotiate extra protections such as a guarantee from the parent company, restrictions on paying dividends, or a requirement to maintain a minimum level of cash.
Investors in unsecured notes should read the document closely before they commit. Key points include the events of default (the failures that let the lender demand immediate repayment), whether the note can be sold to someone else, and what the issuer must report each quarter.
Those terms decide how much real protection exists in the absence of collateral.
In practice
Real-world examples.
Example
A regional restaurant group raises $2,000,000 by selling unsecured notes to local investors with a three-year maturity. The notes pay quarterly interest and carry a covenant limiting how much new debt the group can add. The money funds two new sites, and the group publishes its results to the noteholders each half year.
Example
A software company with strong subscriptions issues $10,000,000 of unsecured notes to institutional investors. No assets are pledged, because the lenders are comfortable with the company's recurring revenue. The company discloses the notes as long-term debt.
Example
A founder lends her own start-up $100,000 through an unsecured note at 8% interest, to be repaid in two years. Because the note is unsecured, she ranks alongside other unsecured creditors if the company is wound up, and she asks for a personal guarantee from the other directors.
Formula
Calculation
Annual interest = principal x interest rate
Extra cost of being unsecured = principal x (unsecured rate - secured rate)
Suppose a company issues a $500,000 unsecured note at 10% a year. Annual interest = 500,000 x 0.10 = $50,000. A similar secured loan would have cost 7%, or 500,000 x 0.07 = $35,000. The extra cost of being unsecured = 50,000 - 35,000 = $15,000 a year, which equals 500,000 x 0.03.Case study
Seen in the real world.
Brookline Packaging is an illustrative, fictional company that needed $1,500,000 for new machinery. Its bank was willing to lend against the machinery at 6%, but only if the company also pledged its inventory, which it needed for a larger supplier loan.
The finance director therefore issued unsecured notes of $1,500,000 at 9% to private investors. The extra interest was 1,500,000 x 3% = $45,000 a year, but the inventory stayed free to support other borrowing.
Two years later sales fell and the investors asked for a meeting, because covenants had been breached. The finance director offered a revised repayment plan and a higher rate for a year to avoid default. The illustrative lesson is that unsecured notes give freedom with assets, but the covenants can bind the company just as tightly.
Watch out
Common mistakes.
- Believing that an unsecured note has no legal force, when the borrower is still legally obliged to pay interest and principal on time.
- Comparing interest rates on secured and unsecured notes without allowing for the difference in risk, which is the reason for the higher rate.
- Forgetting to record the note and accrued interest as liabilities, which understates the company's debt.
Questions
People also ask.
How is an unsecured note different from a debenture?
The words overlap, and in some places a debenture is a secured instrument while in others it describes an unsecured bond, so the document itself must be read.
What happens to an unsecured note if the company becomes insolvent?
Noteholders rank with other unsecured creditors, behind secured lenders, and typically recover only part of the amount.
Can the lender protect itself without collateral?
Yes, through covenants, a parent or director guarantee, and negative pledge clauses.
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