Priority of notes: Overview, definition, and example
What is priority of notes?
Priority of notes refers to the order in which various debt instruments (such as promissory notes, bonds, or loans) are repaid in the event of a default or liquidation of the borrower’s assets. This concept is particularly important in scenarios where multiple creditors hold different types of debt from the same borrower. The "priority" of a note determines which creditors get paid first. Senior debt or senior notes are generally repaid before subordinated debt or junior notes. The terms of these priorities are typically outlined in the loan agreement or bond indenture.
In simpler terms, priority of notes is the ranking of debts, which determines who gets paid first when a borrower faces financial trouble.
Why is priority of notes important?
Priority of notes is important because it helps define the risk and return for creditors. Creditors with higher priority (senior notes) are more likely to be paid back first in the event of default, while creditors with lower priority (subordinated notes) may only get paid if there are remaining funds after higher-priority debts have been satisfied. This system provides clarity and fairness in debt repayment, ensuring that creditors understand their level of risk.
For SMB owners, understanding priority of notes is crucial when taking on multiple loans or issuing debt securities, as it affects both the cost of borrowing and the risk associated with taking on debt. The higher the priority of the debt, the more attractive it is to lenders, often at a lower interest rate, because they face less risk.
Understanding priority of notes through an example
Let’s say your business has issued two types of notes:
- Senior Notes: A $500,000 loan from a bank with a 5% interest rate. These notes are considered senior, meaning they have the highest priority in the event of liquidation.
- Subordinated Notes: A $200,000 loan from an individual investor with a 10% interest rate. These notes are subordinated, meaning they rank lower in priority compared to the senior notes.
If your business were to default and liquidate its assets, the senior note holders (the bank) would be paid first. Only after the senior notes are fully satisfied would the subordinated note holders (the individual investor) receive payment, and only if there are remaining funds. If the business's assets are insufficient to cover both debts, the subordinated note holders may not receive any payment.
Example of a priority of notes clause
Here’s how a priority of notes clause might look in a debt agreement:
“In the event of any liquidation or bankruptcy, the holders of Senior Notes shall have priority over the holders of Subordinated Notes in receiving repayment. The Subordinated Notes will only be repaid after all obligations to the Senior Notes have been satisfied in full. If the assets are insufficient to fully repay the Senior Notes, no payments shall be made to the holders of Subordinated Notes.”
Conclusion
Priority of notes is a critical concept in managing debt and understanding the repayment structure for businesses. It determines how creditors will be paid in the event of financial distress, protecting those with senior claims and clearly outlining the risks for those holding subordinated debts. For SMB owners, understanding the priority of notes can help with decision-making when taking on debt, managing financial risk, and negotiating favorable loan terms.
By clearly defining the priority of any debt issued, businesses can attract more favorable lending terms and manage their borrowing structure to minimize risk and maximize the chances of retaining financial stability.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.