Key Takeaways:

  • Definition & Importance: A promissory note is a legal financial instrument that establishes a borrower’s promise to repay a loan under specific terms. It provides clarity and legal backing for both parties.
  • Types of Promissory Notes: Includes secured, unsecured, convertible, and demand notes, each with unique terms and conditions.
  • Legal Considerations: Promissory notes must meet contract law requirements, including consideration, mutual agreement, and capacity.
  • Common Uses: Used in business transactions, personal loans, student loans, real estate financing, and corporate borrowing.
  • Investment Risks & Fraud Awareness: Some promissory notes, especially those marketed as investments, can be fraudulent. Investors should verify legitimacy through regulatory bodies.
  • Key Terms to Include: Principal amount, interest rate, repayment terms, default consequences, collateral (if applicable), and governing law.
  • Comparison with Other Instruments: Promissory notes differ from IOUs, loan agreements, and mortgages, primarily in their formality and enforceability.
  • Legal Recourse & Enforcement: If a borrower defaults, lenders may take legal action, garnish wages, seize collateral, or sell the debt to a collection agency.
  • Attorney Assistance: Consulting an attorney ensures a promissory note complies with state laws and protects both lender and borrower.

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.

Common Uses of Promissory Notes

Promissory notes are widely used in various financial and business transactions. Some of the most common applications include:

  • Personal Loans: Individuals use promissory notes for lending money to friends or family members with clearly defined repayment terms.
  • Real Estate Financing: Private lenders and real estate investors often use promissory notes for property transactions, sometimes secured by mortgages.
  • Student Loans: Federal and private student loan agreements frequently rely on promissory notes, obligating borrowers to repay educational debts.
  • Corporate Borrowing: Companies may issue promissory notes to raise capital or facilitate business transactions.
  • Installment Sales: When selling expensive items like vehicles or equipment, sellers may accept promissory notes as part of the payment structure.

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.

Risks and Fraudulent Promissory Notes

While promissory notes are legitimate financial tools, they can also be misused in fraudulent schemes. Investors should be cautious of:

  • Guaranteed High Returns: Promissory notes offered as investments promising unrealistic returns often indicate fraud.
  • Lack of Registration: Many fraudulent notes are unregistered securities, violating federal and state laws.
  • No Clear Issuer Information: If the note lacks details about the issuing company or borrower, it may be a scam.
  • Short-Term Maturity with High Interest: Some fraudulent notes promise quick, high-yield returns but collapse before payments are made.
  • Check with Regulators: Investors should verify a promissory note's legitimacy with regulatory bodies such as the SEC or FINRA before investing.

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.

Examples

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.

Common Mistakes

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.

Legal Enforcement of Promissory Notes

If a borrower fails to meet the repayment obligations outlined in a promissory note, the lender has several legal options:

  1. Demand Payment: The lender can issue a formal demand letter requesting repayment before taking further action.
  2. Negotiate a Settlement: Lenders and borrowers may renegotiate terms to avoid litigation, such as extending the repayment period or reducing the interest rate.
  3. File a Lawsuit: If the borrower refuses to pay, the lender can take legal action to obtain a court judgment.
  4. Garnish Wages or Seize Assets: If the court rules in favor of the lender, the borrower’s wages or assets may be garnished to recover the owed amount.
  5. Sell the Debt to a Collection Agency: Lenders can transfer unpaid promissory notes to debt collection agencies for a fraction of their value.

Frequently Asked Questions:

1. Are promissory notes legally binding?

Yes, promissory notes are legally enforceable documents as long as they contain key terms and are signed by both parties.

2. Can a promissory note be modified?

Yes, if both the borrower and lender agree, a promissory note’s terms can be amended, such as adjusting the repayment schedule or interest rate.

3. What happens if a promissory note is not paid?

If a borrower defaults, the lender can take legal action, garnish wages, seize collateral (if applicable), or sell the debt to a collection agency.

4. How do I know if a promissory note is legitimate?

Legitimate promissory notes are issued by reputable lenders, contain clear terms, and may be registered with financial regulatory agencies.

5. Can a promissory note be transferred to another party?

Yes, promissory notes can be sold or assigned to another party, transferring the lender’s right to receive payment.

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.