“Promissory notes are legal contracts that outline the terms of a loan and enforce the promise that a borrower will repay a loan within a specified period. Obtaining financing for your company through promissory notes is an easy process. They are usually simple documents with little formality. A napkin promissory note could be valid if you include the required terms.”
You can also call it a personal note, a loan agreement, a promissory note form, a promise to pay, a note payable, a note payable, a promissory note form, a promise to pay, or a demand note.
Therefore, a Venture Promissory Note must also contain all the usual contract requirements, such as consideration, mutual agreement, and capacity. It can be subject to the same defenses as a contract, such as fraud or misrepresentation. Promissory notes also include the following:
- Parties’ names
- Borrowing amount.
- Repayment amount.
- The frequency and date of payments (e.g., monthly or lump sum), respectively
- Fixed, variable, or increasing interest rates.
- If a loan needs to be repaid or a payment is late.
- Security for the Loan, such as collateral or property.
- Is the note transferable or assignable?
- Issuance date and location.
- Signature of the issuer.
In some cases, terms may overlap or be mutually exclusive, such as a note that is repaid in full at once without a repayment schedule. Otherwise, the interest rate may not be specified explicitly.
Why Is a Venture Promissory Note Important?
A promissory note provides easy access to funds. By putting the terms in writing, both parties gain protection. The most common convertible promissory note options are:
- An automatic conversion occurs when the lender does not receive payment by a certain date.
- Instead of cash repayment, lenders can take equity.
- In place of cash repayment, the borrower can give equity.
As a result, convertible promissory notes are important as they allow for a delayed formal valuation, allowing for a rise in value before equity is priced and sold, and they are less expensive and faster.
Who Can Use a Promissory Note?
People use these notes to pledge to pay back any debts they owe shortly when they take money from someone else. The legal binding of a promissory note is the person who borrows it with the lending institution, regardless of whether they are a person or business. Personal loans, auto loans, mortgages, and student loans are just some of the loans promissory notes can secure.
Many lenders require the borrower to execute a promissory note as the final step in their loan request process to prove their commitment to pay back the total debt and interest.
Promissory notes are like formal loan agreements containing some of the same components as an IOU. These components include:
- Interest plus the total amount owed
- A timeline of events
- Repayment terms
Unlike a loan agreement, an IOU confirms that someone owes money but does not impose a deadline for repayment. In formal situations, promissory notes serve in place of legal loan agreements. However, you may use them instead of IOUs for loans to friends and family members.
Reasons to Consider Using a Promissory Note
The following circumstances may warrant the use of a promissory note:
- It’s not a wise option to sell equity.
- A complete securities offering would be prohibitively expensive for you.
- A business loan should not be reported on your credit report.
- It is necessary to establish when founders can take the money they lent to their businesses.
- A Promissory Note May Not Be Necessary
- There could be better options other than promissory notes for certain scenarios. Be aware of the possible disadvantages:
- Lenders might require a formal contract if they lend larger amounts of money.
- Debt financing isn’t a viable option for your business.
- The lender can purchase your assets during bankruptcy in exchange for the amount you owe if you fail to pay the promissory note.
You can structure your promissory note in virtually any way you like. Here are a few possibilities:
- A $10,000 loan for $250 per month with a 5 percent interest rate.
- After 24 months, the Loan will be repaid with $1,200.
- Full repayment within three years is necessary for a $50,000 loan to become a 10 percent equity stake.
- Upon repayment, the borrower can either pay 8 percent interest or take a 5 percent equity stake.
You can pay through a variety of methods, such as:
Lump Sum: A single payment by the borrower to the lender will cover the entire amount
Due on Demand: If the lender gives the borrower a reasonable amount of time before the demand is made.
With Interest: A monthly interest rate is charged to the borrower. Repayments are made first to the interest and then to the principal.
The informal nature of promissory notes can result in mistakes. These mistakes can result in costly litigation or increased debt obligations.
- Inclusion of all necessary terms in the contract.
- You need more cash flow to pay your bills on time.
- Other debt or equity holders’ covenants prohibiting additional borrowing are violated.
- You are not protecting your assets in the event of a default.
- Violation of securities laws when soliciting funds.
How Do You Draft a Promissory Note?
A promissory note will have different legal requirements depending on your state. Still, all must include an unconditional commitment to repay debt, due dates, payment methods, and the total amount owed, including any interest and principal.
Getting the help of an attorney can also help you draft a legally binding promissory note. You can ensure that your promissory note contains all the necessary elements and provides the most protection.
- Steps to Use a Promissory Note
- Use a promissory note as follows:
- Make sure you can repay the Loan by performing financial due diligence.
- Consider less expensive alternative funding options.
Every time you prepare a promissory note, check the terms carefully because standard forms may miss important provisions or contradict your intentions. Keep copies of the agreement for your records and execute the agreement.
Is a Promissory Note a Loan?
There is no such thing as a promissory note or a loan agreement. A loan agreement consists of a more formal contract between the borrower and the lender, with more terms and conditions and legal consequences.
If you borrow a large amount of money, you will often need a more comprehensive loan agreement. The lender cannot seize your assets if you default on a secured loan agreement; secured loans may allow the lender to seize collateral or property if you default on the agreement.
Friends and family use promissory notes to guarantee repayment of debts. But they still need interest rates and repayment deadlines.
Key Elements All Promissory Notes Should Include
Promissory notes can take various forms, but they must all include the following ten elements, called material terms:
· Names and Contact Information
You’ll need information on both parties (the lender and the loan recipient).
· Total Loan Amount
Specify the currency to get an estimate of how much the borrower owes you.
· Interest Rate on the Loan
Any loan between family members should include an interest rate, which makes it official and ensures you can deduct any unpaid debt on your taxes if you fail to pay.
Incorporate any collateral we used to secure the Loan (this will be spelled out in a security agreement section).
It’s only legal if both parties sign the promissory note. If not, it’s just paper!
· Payment Frequency, Amount & Time Frame
Write down when the borrower should make their first payment, how much that payment should be, the due dates, and how many principal and interest payments you will need.
· Extra Fees
Any additional charges, fees, or conditions are the following.
· Date and Location
The location and date of the creation of the promissory note should be listed.
There must be a transferable promissory note on the loan agreement that allows a third party to collect the funds by selling the promissory note as security.
What Makes a Promissory Note Invalid?
The following are five reasons for the invalidation of promissory notes in court, just like any legal document. In drafting your promissory note, be sure to avoid these mistakes.
· Incomplete signatures.
Using your legal name when signing any binding agreement is always a good idea. Make sure the signatures are legible and complete.
· We need to include dates.
We design promissory notes to ensure lenders receive the money loaned to borrowers by a set date. Unless they specify a due date, they are nothing more than an IOU.
· No interest rates.
There is a minimum interest rate even for personal loans. A gift loan under $10,000 between individuals with no interest may not qualify as a legal loan under your state’s law-section 7872 of the Internal Revenue Code prohibits gift loans under $10,000 from having any interest charged.
· No original copy.
During the loan term, you may amend your promissory note. If so, you will need a copy of the initial document. Amended versions are generally only considered valid with the original document to compare.
· Unreasonable terms.
Promissory notes cannot include unreasonable or exploitative terms you can enforce on the other party. Consult with a promissory note attorney to determine what is reasonable and unreasonable.
Can you amend a promissory note?
Even when you sign a loan agreement, it is only sometimes the last step. Sometimes you will need to amend your loan agreement. How can you do this? To amend a promissory note, you should know the following:
- You can create a legally binding addition to the loan agreement by amending the documentation and re-establishing the new version.
- Keep the original document for reference even if the terms of the agreement change.
- The borrower and the lender must agree on the terms before the amendments become effective. 🤝
- Neither party should rely on a signature from the original document that won’t stand up in court. Instead, both parties must sign the amended document again.
If you used Pigeon for your original promissory note, you should use Pigeon again to amend it. Creating an amended loan agreement based on the template or service you used previously is best. This ensures you don’t accidentally void the document using inaccurate language or unfair terms (see below).
Frequently Asked Questions
The following questions are commonly asked about promissory notes:
Is a promissory note legally binding?
Promissory notes are legal contracts that the courts enforce.
Are promissory notes subject to any legal restrictions?
A promissory note is generally governed by state law, with the most common restrictions covering interest rates and secured loans. If the parties come from different states, specify which state’s laws govern the note in the agreement.
Is a promissory note subject to SEC regulation?
It is likely to be exempt from regulation if you ask a friend or relative for a loan. It may qualify as a securities offering if you solicit funds from a third party.
What will happen in the case of late or nonpayment?
A promissory note should specify whether interest or late fees apply. A lender can file a lawsuit if the borrower fails to pay the balance in full. Some lenders may also be able to send their debt to a debt collection agency if the debt is not paid in full.
Alternatively, the lender can restructure the Loan and change the amount owed or the time frame for recovering a portion of the Loan through a debt settlement agreement.
Can we modify a promissory note?
Borrowers and lenders may change the terms of an agreement at any time if all parties agree. For example, the borrower could ask for a higher interest rate in exchange for a longer payment period.
Difference between a promissory note and an IOU and mortgage.
In general, there are two types of loans, one known as an IOU and the other known as a loan agreement or loan contract, which is more formal and is usually used by banks. Mortgages are secured loans that back up by real estate.
If your startup needs help raising money, get in touch with Attorney real estate group. We have helped countless companies, and we can help yours as well.