Promissory Note: Everything You Need to KnowStartup Law ResourcesVenture Capital, Financing
A promissory note is a legal contract that sets the terms of a loan and enforces the promise for a borrower to pay back money to a lender within a time period5 min read
Promissory Note: What Is It?
A promissory note is a legal contract that sets out the terms of a loan and enforces the promise for a borrower to pay back a sum of money to a lender within a certain time period. Promissory notes are one of the simplest ways to obtain financing for your company. They are often basic documents with few formalities. A promissory note written on a napkin could be valid if the required terms are included.
Alternative names for promissory notes include: IOU, personal notes, loan agreements, notes payable, note, promissory note form, promise to pay, secured or unsecured notes, demand notes, or commercial paper.
As such, a promissory note must contain the usual standard requirements for a contract, including consideration, meeting of the minds and capacity. The same defenses can apply, such as fraud or misrepresentation, in the event the validity of the note is contested.
A promissory note also includes the following:
- The names of the parties
- The amount borrowed.
- The amount to be repaid.
- When and how often payments are made (e.g., monthly or lump sum), as well as the dates, as applicable
- The interest rate and whether it's fixed, variable, or increases over time.
- What happens if there's a late payment or the loan isn't repaid.
- Who is responsible for repaying the loan.
- Whether any collateral or property secures the loan.
- Whether there are any rights of transferring or assigning the note.
- The date and place of issuance.
- The issuer's signature.
Note that some terms may overlap or be mutually exclusive. A note that is repaid all at once may not have a repayment schedule. The interest rate may not be explicitly stated if the note includes the total amount to be repaid.
Why Is a Promissory Note Important?
Promissory notes provide flexible options to easily obtain funds. Putting the terms in writing protects both the lender and the borrower.
A convertible promissory note backs the loan with equity in the company. The most common options include:
- Automatic conversion, where the lender receives equity if repayment isn't made by a certain date.
- Lender option to take equity instead of cash repayment.
- Borrower option to give equity instead of cash repayment.
Convertible promissory notes are favored because it allows the company to delay giving a formal valuation, which mean it can increase value before equity is priced and sold, and these notes are faster and less expensive.
Reasons to Consider Using a Promissory Note
You may want to use a promissory note in the following circumstances:
- You don't want to give up equity.
- You don't want to take on the expense of a full securities offering.
- You want the debt in the name of your business not on your personal credit.
- You need to clarify when founders can withdraw money loaned to the company.
Reasons to Consider Not Using a Promissory Note
A promissory note may not always be your best option. Consider the following possible drawbacks:
- Unsecured loans typically carry higher interest rates.
- Lenders may require a more formal agreement before lending larger sums of money.
- Your business doesn't have the cash flow to support debt financing.
- Promissory notes may still be considered a public securities offering.
- If you don’t pay the promissory note, the lender could buy your assets in bankruptcy for the amount of outstanding debt.
Promissory notes can take on virtually any form. Here are just a few possible structures:
- $10,000 loan with 5 percent interest repayable at $250 per month until paid in full.
- $1,000 loan to be repaid in the amount of $1,200 after 24 months.
- $50,000 loan convertible to a 10 percent equity stake if not repaid in full within three years.
- $25,000 loan with a borrower option to repay with either 8 percent interest or a 5 percent equity stake.
Payment methods can take on different forms such as:
Lump Sum: the borrower will pay the full amount in a single payment to the lender
Due on Demand: the borrower will repay the lender when the lender requires it given a reasonable amount of time before the demand is made
With Interest: the borrower is charged an interest rate such as a monthly interest rate and repayments are charged towards the interest due first and the principal, or the amount borrowed, afterwards.
Because promissory notes can be informal, there is a risk of not taking proper care when creating one. Mistakes can lead to costly litigation or additional debt expenses. Here are some of the common mistakes:
- Not including all necessary terms in the agreement.
- Not ensuring you have adequate cash flow to make timely payments.
- Violating covenants with other debt or equity holders that prohibit additional borrowing.
- Failing to protect your personal assets in case of default.
- Soliciting funds in a way that violates securities laws.
Steps to Use a Promissory Note
Take the following steps when using a promissory note:
- Do financial due diligence to ensure you can repay the loan.
- Compare other funding options for lower cost alternatives.
- Do not solicit a loan from outside sources without speaking to an attorney. This could be considered a public offering unless you meet the requirements of Regulation D, the JOBS Act or another exemption.
- Carefully review the terms of the promissory note every time. Standard forms may not include important provisions or may contradict your intent.
- Execute the agreement, and keep copies securely stored for your records.
Frequently Asked Questions
These are some of the most frequently asked questions about promissory notes:
- Is a promissory note legally binding?
Yes, promissory notes are legally binding. They are enforced as contracts.
- Does the law place any restrictions on promissory notes?
Promissory notes are generally governed by state law. The most common restrictions cover interest rates and secured loans. Be sure to specify in the agreement which state's law controls the note if the parties are from multiple states.
- Is a promissory note subject to SEC regulation?
Possibly. A loan from a close friend or family member is likely exempt. If you solicit funds from outside parties, it may be considered a regulated securities offering.
- What happens in the event of late payments or nonpayment?
The promissory note should set out any interest or late fees that apply. If the borrower does not pay in full, the lender has a right to file a lawsuit for the outstanding balance. In some cases, the lender may also have the option to send the debt to a debt collection agency. Another option is to use a debt settlement agreement where the lender restructures the loan and changes the amount owed or the amount of time to recover a portion of the loan.
- Can a promissory note be modified?
Yes, if the borrower and lender both agree, the terms can be changed at any time. For example, the borrower might ask for more time to pay in exchange for a higher interest rate.
- What's the difference between a promissory note and an IOU, loan agreement and mortgage?
The main difference is in the names not the function. IOUs are generally less formal and may not have exact repayment terms. Loan agreements or loan contracts are more formal and are often used by banks. Mortgages secure a loan with the title to real property.
Work With an Attorney
To protect your legal rights, consider having an attorney review every promissory note you use. UpCounsel has a directory of qualified lawyers in your area who are available on demand. You can request a free proposal in minutes.