Every entrepreneur at one time or another has probably sat around the dinning room table presenting his or her brilliant business concept to an uncle, college buddy or colleague hoping to fineness a check for $10,000. Money from family, friends or acquaintances is often the fastest and cheapest source of capital available to budding entrepreneurs. These types of loans account for more than 50 percent of all start-up business investment dollars.
Banks provide their own promissory note forms, but if you borrow money from an individual, you'll need to come up with one on your own. There are emotional pitfalls to loans between family and friends, along with financial risks and administrative requirements, says Asheesh Advani, author of Business Loans from Family and Friends: How to Ask. Make It Legal & Make It Work. Advani became the pioneer behind the business of managing person-to-person loans when he founded CircleLending, which became Virgin Money USA when it was later acquired by Richard Branson's Virgin Group.
Advani says that too often, small business owners fail to follow the basic but important lending guidelines when they borrow from an individual. The neglect can result not only in any number of personal conflicts but also tax difficulties, says Advani, who has personally raised several million dollars from 75 private investors, mostly family, friends, and business associates.
Documenting the loan can do no harm, and it can head off misunderstandings about whether the money is a loan or a gift. With a gift no repayment is expected, a loan requires repayment, while an equity investment is in return for shared ownership.
The obvious reason to hammer out all the details of the loan in writing is to keep harmony. Second, it becomes a taxing situation if you can't prove the loan is formal and legal. Many entrepreneurs have been dragged into IRA audits over personal loans.
Let's say you deposit a $30,000 check from your Aunt Jane; your bank automatically informs the IRS about the deposit. In fact, all deposits over $10,000 are reported to the IRS. When the deposit does not show up on your personal or business taxes as income, the IRS will want to know why.
Always keep in mind this is debt obligation. "A promissory note means that by nature you have the money to make payments on the loan," cautions Danny Freeman, principal advisor with Darda Financial Services in Winston-Salem, North Carolina. Be sure to have the cash flow to service the debt, he says. "If you have uneven cash flow you should not enter into a promissory note; perhaps you should look into an equity arrangement."
Treat a personal loan as carefully and as formally as any other business transaction.
How To Write A Promissory Note: Preparing a Promissory Note
A promissory note is pretty much a do-it-yourself document. It is a simple contract whereby the borrower creates a note promising to pay the money back by a certain date.
There are free promissory notes or personal loan agreement forms available online. But also take a look at forms in Nolo Press's Quicken Legal Business Pro software.
"Most of the time you can find a form that fits your situation. If there is something unusual about the repayment terms, then it may make sense to have the note reviewed by a lawyer," says attorney Fred S. Steingold, author of Legal Forms for Starting & Running a Small Business.
Freeman says the need for a lawyer rises with the more money you are trying to borrow. "For a $1,000 note it doesn't make economic sense to hire an attorney. But if you are talking more than tens of thousands of dollars consider consulting an attorney."
A promissory note basically includes the name of both parties (lender and borrower), date of the loan, the amount, the date the loan will be repaid in full, frequency of loan payments, the interest rate charged on the loan payments, and any security agreement.
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How To Write A Promissory Note: Scheduling Repayment Terms
When you sit down to create a schedule for your repayment, think first about what you can afford, and create a schedule that makes keeping up with your payments possible, advises Advani. With private loans you have the option of designing a repayment plan that is more in line with the business' expected profits. A promissory note usually requires making that first payment in 30 days. But you could have a six month grace period after which point regular payments are made with an interest-only agreement.
The legal and practical terms of promissory notes can vary considerably, but the most important thing is to set a repayment plan that's right for you, says Steingold. Here are three types of repayment schedules to explore:
1. Amortized payment: You pay the same amount monthly or annually for a specified number of months or years. Part of the payment goes toward the interest and the rest goes toward principal.
2. Interest only payment and final balloon payment: You make regular payments of interest only over a number of months or years. However, the principal does not decrease. At the end of the loan, you must make a final payment to repay the principal and remaining interest.
3. Single payment of principal and interest: You can opt to pay the loan off all at once and avoid regular ongoing payments. At a specified future date, you would pay the entire principal amount and accrued interest. This is best for short-term loans.
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How To Write A Promissory Note: Charging Interest
There is no legal limit to the amount you can borrow, it can be anywhere from $1,000 or $1 million. However, there are guidelines about charging interest. The lender must charge an interest rate that reflects fair market value. This has to be at least the applicable federal rate, which is another of layer of scrutiny the IRS uses to determine if this is really a gift or a loan. You can find at list of rates at the IRS.gov. The AFR is adjusted monthly and currently ranges from around 0.7 percent on loans of three years or less to under 4.5 percent on loans longer than nine years.
Do a statewide search. States have usury laws for the highest rate of interest you can charge on personal loans, says Steingold. This was done to reign in predators and loan sharks. Check online or a law library for your state statues.
What type of credit risk is being taking on? That should also dictate how much interest is assessed, suggests Freeman. If you as the borrower are a good credit risk (you have the ability to pay and the assets to back it up) then the interest charged should be at the lower end of the spectrum and vice versa, Freeman explains.
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How To Write A Promissory Note: Pledging Security
The advantage of borrowing money is that you don't have to give up equity ownership in the business. You just have a financial obligation to pay your debt. However, sometimes a lender may want a security agreement, meaning that you are pledging or offering some type of collateral.
"If you are going to offer collateral than that needs to be listed on the note and the terms under which if you go into default what happens to the collateral to satisfy the obligation," says Freeman. "And it needs to also clearly spell out that if the collateral is liquidated for more than what is owed on the note then who get the excess."
Once you agree on the loan terms, be aware if you are signing on behalf of the business or yourself, says Freeman. "Are you personally liable for the loan versus signing it as a representative of your business entity whether it is a corporation or LLC?"
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How To Write A Promissory Note: Handling Missed Payments or Loan Default
You don't have to be an entity; any individual can garnish another person's business and personal bank accounts for failure to payback a loan. Once a borrower defaults and property or business assets are pledged, a lender can take legal action in terms of a lawsuit. The lender would go to court and get a judgment for attachment of property and force a sale to satisfy the debt. Seizing furniture or business equipment which can be sold to satisfy the debt is also recourse.
You have to be as specific as possible. "Sometimes a note will state that once a payment is missed then the loan is accelerated and the entire amount becomes due at that point," adds Freeman. Make sure there is a clause that says there is no prepayment penalty.
Above all, have the promissory note witnessed by a notary.
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