How to Write a Promissory Note
Raising money from family or friends is easy capital. Just be sure to follow basic but important lending guidelines when making a binding agreement to pay it back.
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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.
Dig Deeper: The Promissory Note Template
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.
Dig Deeper: Borrowing Money for Your Business
