A promissory note is a legal contract obligating the person who signs it to pay a certain sum of money to another person at a later date and outlining the terms of payment. Like a loan agreement, the person owing the money is called the borrower (or sometimes the payor). The person who is owed the money is called the lender (or sometimes the payee). A promissory note can also be called a note payable, or simply a note.
Most promissory notes offer borrowers a faster, flexible, and more cost-effective way to secure a loan. They’re especially useful for entrepreneurs, but also for commercial lending and personal loans. The most common types are secured promissory notes, but there are also unsecured notes and convertible notes.
Key takeaways
- A secured promissory note is a written borrower’s promise to repay a loan that includes collateral the lender can claim if the borrower defaults on the promissory note.
- A legally binding promissory note includes the collateral, interest rate, maturity date, or loan repayment terms, and the names of the lender and borrower.
- Compared to unsecured notes, secured notes offer more protection for lenders and may lead to better loan terms for borrowers.
What is a secured promissory note?
A secured promissory note is an obligation to pay that is secured by some type of property. It’s a promissory note with collateral: If the borrower fails to pay, the lender can seize the designated property. By assuring that the value of the property attached to the note can cover the amount of the loan, the lender feels more secure that they will be repaid. Secured promissory notes are most often used in loans of fairly large sums borrowed from commercial lenders.
The property that secures a note is called collateral, and it’s usually either real estate or personal property. A promissory note secured by collateral will need a second document. If the collateral is real property, there will be either a mortgage or a deed of trust. If the collateral is personal property, there will be a security agreement.
If the borrower fails to pay as required by the note, the lender will typically need to file a lawsuit to foreclose on the mortgage or security agreement. If the borrower files for bankruptcy, the lender’s right to the property securing the loan comes before the rights of any unsecured creditors.
Lenders typically prefer secured notes, as they give the lender the most assurance of getting paid.
Other types of promissory notes
Not all promissory notes are secured by collateral. Depending on the situation, you might use a different type of note with its own features and risks.
Unsecured promissory notes
An unsecured promissory note is an obligation for payment without any property securing the payment. It’s typically used when borrowing money from a friend or relative—financial institutions rarely (if ever) use them. If the borrower fails to pay, the lender must file a lawsuit and hope that the borrower has sufficient assets that can be seized to satisfy the loan. If the borrower does not have sufficient assets, the lender is out of luck. If the borrower files for bankruptcy, the lender's claim is behind the claims of any secured creditors.
Convertible promissory notes
A convertible promissory note is a debt instrument that provides investors with the right to convert their loan into equity shares of an issuing company upon certain triggering events. This financial tool combines the same key elements of traditional debt with the potential upside of equity ownership, making it particularly attractive for startup financing.
Unlike standard promissory notes that require cash repayment, convertible notes give investors the option to exchange the debt for company ownership. This conversion typically occurs during a qualified financing round, at the note's maturity date, or upon a company sale or acquisition. The conversion terms are predetermined and outlined in the note agreement, providing clarity for both parties from the outset.
For startups, convertible promissory notes are particularly common in seed funding rounds, bridge financing between larger equity rounds, and situations where they need capital quickly. They allow companies to defer valuation discussions until they have more operating history or reach specific milestones, which often results in better terms for both parties.
Secured vs. unsecured promissory notes
Secured and unsecured promissory notes have different risk profiles and protections for both the borrower and the lender. Here’s a more direct breakdown of secured vs. unsecured promissory notes.
Secured promissory notes are backed by specific assets or collateral. If the borrower defaults on the promissory note, the lender has the right to claim the designated collateral to recover their investment. Secured notes reduce risk because there’s something to collect if the loan isn’t repaid. But they take more paperwork and sometimes involve legal filings.
Unsecured promissory notes are not backed by specific collateral, making them more common for certain types of loans and investments. Unsecured notes may come with higher interest rates, but give borrowers more flexibility. Most seed-stage convertible promissory notes are unsecured, as early-stage companies typically have limited tangible assets to pledge as collateral.
| Feature | Secured Note | Unsecured Note |
|---|---|---|
| Collateral | Yes (property or asset) | No |
| Risk to lender | Lower (backed by collateral) | Higher (no backup if borrower fails) |
| Enforcement options | Can repossess or foreclose | Must sue to collect |
| Common use cases | Business loans, equipment, real estate | Personal loans, small short-term debt |
The bottom line
Use a secured note when the loan amount is large or if the lender wants extra protection, for example, if you’re starting a business. If you’re lending money, only use an unsecured note if there’s a strong relationship and a high amount of trust between you and the borrower, or if the loan is small and short-term.
Key terms of a secured promissory note
The terms of a secured promissory note determine how it functions and what protections and benefits each party receives. A legally binding secured promissory note template will contain certain terms that each serves a specific purpose in balancing risk, reward, and operational flexibility.
Collateral agreement
The collateral agreement is what separates a secured promissory note from an unsecured one. The borrower pledges something of value—called collateral—as a backup if the loan isn’t paid. This could be real estate, a car, business equipment, or even inventory. The lender can legally seize ownership of the collateral if the borrower defaults on the promissory note.
Interest rate
The interest rate on secured promissory notes is generally lower than traditional debt instruments because the lender has more assurance they’ll be repaid. Interest accrues from the lending date and is usually compounded annually, but can also be a flat rate.
Maturity date
The maturity date establishes when the note must be repaid. Most secured promissory notes have maturity periods of 12 to 24 months. If the note reaches maturity without being repaid, the lender typically has the right to repossess the collateral or take legal action, though many agreements include provisions for extending the maturity date.
Additional provisions
A promissory note can also include other terms like:
- Prepayment: Whether the borrower can pay off the loan early without penalties
- Transferability: If the lender can transfer the note to someone else
- Governing law: Which state’s laws apply if there’s a dispute
For entrepreneurs and investors: Convertible promissory notes
The convertible note process typically unfolds over months or years, depending on the company's growth trajectory and financing needs. Unlike traditional loan agreements with fixed repayment schedules, convertible notes are designed to evolve with the company's development, providing flexibility that benefits both startups and investors.
The convertible note process: Step by step
- Note issuance and funding. The startup and investor agree on the principal amount, interest rate, maturity date, and conversion terms. Once signed, the investor provides the agreed-upon capital to the company.
- Interest accrual period. During the note's term, interest accrues on the principal amount at the agreed rate.
- Triggering event occurs. Conversion is triggered by predetermined events such as a qualified financing round (usually $1 million or more), company sale, or maturity date.
- Conversion calculation. When triggered, the note converts using the predetermined formula, often incorporating valuation caps and discount rates to benefit early investors.
- Equity issuance. The debt converts into preferred or common shares, and the investor becomes an equity holder with corresponding rights and protections.
Legal considerations for convertible notes
Companies must ensure their note offerings comply with applicable federal and state securities regulations, which may require specific disclosures, filing requirements, or investor qualification standards.
Companies must also provide appropriate disclosures to investors, including risk factors, financial information, and material business developments. The level of disclosure required depends on the exemption used and the sophistication of the investors involved. State securities laws, often called "blue sky" laws, may impose additional requirements or restrictions on convertible note offerings.
When to consult legal counsel
Given the complexity of securities law and the long-term implications of convertible note terms, companies should consult with experienced securities attorneys before issuing these notes. Legal counsel can help ensure compliance with applicable regulations, draft appropriate documentation, and structure terms that align with the company's long-term strategy.
Investors should also consider legal review, particularly for larger investments or when the note terms include unusual provisions. Understanding the conversion mechanics, investor rights, and potential outcomes helps investors make informed decisions and avoid unexpected complications.
How LegalZoom can help with promissory notes
Creating legally binding promissory notes requires careful attention to detail. Many borrowers and lenders choose to use secured promissory note templates to ensure they don’t miss any important steps.
Whether you're a borrower preparing your first secured note or a lender who needs to send a notice of default or demand for payment, LegalZoom has promissory note templates you can use. If your note is especially complicated, you can also get help from our network of experienced attorneys. We’re here to help ensure your promissory notes are properly structured and legally compliant.
FAQs about promissory notes
What’s the difference between a secured vs. unsecured promissory note?
A secured promissory note is backed by collateral, like a car or property, that the lender can take if the borrower doesn’t pay. An unsecured note doesn’t include collateral, so the lender must sue to collect if there’s a default. Because of that, secured notes usually carry less risk for the lender, while unsecured notes provide more upside for the borrower.
What’s required to make a promissory note legally binding?
A legally binding promissory note must clearly state the loan amount, repayment terms, interest rate (if any), and the names of the borrower and lender. It must also be signed by the borrower. In some cases, promissory note notarization or witness signatures may be required by state law or if the note is secured by real estate.
What happens if you don’t pay back a secured promissory note?
If you don’t pay back a secured note, the lender can take the collateral through repossession or foreclosure, depending on what was pledged. They might also take legal action to collect the rest of the unpaid debt. The process depends on your state’s laws and the terms in the note.
Can convertible promissory notes be secured by company assets?
Yes, convertible promissory notes can be secured by company assets, though most early-stage startup notes are unsecured. Secured notes provide additional investor protection but may limit the company's operational flexibility and ability to use assets for other purposes. The decision to secure a note depends on the company's asset base, investor requirements, and overall financing strategy.
How is the valuation cap determined in a convertible promissory note?
The valuation cap is typically negotiated between the company and investors based on the company's current stage, market conditions, and growth prospects. It's usually set at a level that provides meaningful upside protection for early investors while remaining reasonable for the company's expected development. Common caps range from $3 million to $15 million for early-stage companies, depending on the industry and company traction.
Edward A. Haman, Esq., contributed to this article.
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