Raising funds to start or expand a business can be challenging. One way many businesses raise capital is with a secured promissory note. The source of the funds can be either a commercial lender or an individual, such as a friend or family member.
Promissory note terminology
Understanding promissory notes requires knowledge of certain terms:
- Promissory note. A legal document that obligates the person who signs it to pay a certain sum of money to another person at a later date. An IOU acknowledges the amount of debt that is owed, but a promissory note adds the terms by which the debt is to be paid.
- Promissor. The person who owes money under a promissory note. This person may also be called the payor, maker, or issuer.
- Promisee. The person who is owed money under a promissory note. This person may also be called the payee.
- Secured promissory note. A promissory note that is tied to property of the promissor. If the promissor fails to pay, the promissee can take the attached property. A promissory note is secured by real estate with a mortgage or deed of trust. A promissory note is secured by personal property with a security agreement.
- Collateral. Property that secures a loan. Collateral can be either real property or personal property.
- Secured convertible promissory note. A secured promissory note that may be converted into an ownership interest in the business, rather than being repaid. The note will state the conditions under which the conversion may occur. However, this can trigger the application of federal or state securities laws, so consultation with a securities attorney is advised if this type of note will be used.
There are several ways by which a promissory note can be paid:
- Installment payments. Payments are made on a periodic basis, most often monthly. Each payment consists of principal and interest, calculated so that the loan is paid in full with the last payment. Installment payments also are referred to as amortized payments, and are the easiest payment arrangement to plan for.
- Lump sum payment. Under this scheme, there are no installment payments of either principal or interest. The full amount is due on a date specified in the note. This can create a problem if you don't have the funds to pay off the loan at the due date. A variation of this is a promissory note payable on demand, which means that there is no specific date set and the loan must be paid in full at any time the promissee requests it. A demand payment on a promissory note makes it impossible to know when payment will be required, and can become a serious problem if the demand is made when funds are not available.
- Balloon payment. This is when there are periodic installment payments, but a sizable amount, or the full amount, of the principal of the loan is due at one time. In some cases, there are smaller periodic payments of principal and interest—which are insufficient to pay the loan off by the due date—so a fairly large lump sum is due at the end of the loan period. In other cases, there are periodic payments of interest only, with the full amount of the principal due at the end of the loan period.
Your individual circumstances will determine which of these three payment arrangements is best for your promissory note.
One option is to obtain a loan from a commercial lender, such as a bank. The lender will require you to sign a promissory note, as well as a security document. If the note is secured by real property, the security document will be a mortgage or deed of trust. If the note is secured by personal property, it will be a security agreement.
For a sole proprietor or a partnership, the owner or partners will be personally liable for the loan. For a corporation or LLC, the lender may require the owner or owners of the business to personally guarantee the loan, which will defeat the limitation of liability normally afforded by these business structures. Such a loan may be secured by property owned by the business, or by property owned personally by the business owners.
Another way to obtain capital for your business is by borrowing money from friends or relatives. This type of transaction also should be formalized with a promissory note. Often, such a personal loan is not secured by property, but securing it can be a way to give assurance to your friends and relatives that they will be repaid.
Caution must be used if you will be seeking personal loans in the name of your business, as this may bring federal and state securities laws into play. Securities laws are complicated, so consulting with a securities attorney is advised.
If you arrange a commercial loan, the lender will provide the necessary forms. But, for a personal loan, you will need to create your own promissory note.