We get a lot of questions from entrepreneurs about how to create a simple financial loan instrument for friends and family. As mentioned in the Make It Big book, these are commonly done using Promissory Notes. This post discusses the basics and presents a template for use.
These notes define the borrower, lender, principle or amount of the loan, interest rate (if any), and terms of repayment. Payments against the principle can be made at regular intervals, ad hoc, or as a lump sum depending on how the terms are structured.
"Promissory notes are a viable financial vehicle between private parties," says Marc Theeuwes, former Venture Capitalist and now Consulting Associate Professor at Stanford University. "They are usually used for friends and family investing where a valuation has not yet been established for the company."
The example Simple Promissory Note below has a principle of 100,000, paid back monthly over five years (i.e., 60 periods), with an interest of 6% (i.e., 0.50% monthly). Any financial calculator such as the HP 12C or spreadsheet program such as Microsoft Excel can calculate the payment. For this example it is $1,933.28. Excel uses the formula PMT. The final note would appear as follows:
************* Simple Promissory Note **************
I, BORROWER , do promise to pay LENDER the loan sum of $100,000. Repayment will be made in 60 equal payments at 6% annual interest, or $1933.28 payable on the 1st of each month, beginning START DATE until the total debt is satisfied.
Borrower Lender
Signed: ___________________________ ______________________________
Date: ___________________________ ______________________________
************* End Note **************
This Simple Promissory Note is an extremely simple example that could only be used in the friendliest of situations. The main issue with this note are the lack of defined recourse should payments stop before the debt is satisfied (i.e., the lender defaults on the note). The note below expands the simple note above by providing more flexible monthly or lump sum payment terms, assignment if the note is to be taken over by another party, and terms in case of default. Entrepreneurs can modify these terms as need be but this sample forms the basic structure of a promissory note.
************** PROMISSORY NOTE **************
- PROMISE TO PAY. FOR VALUE RECEIVED, the undersigned ___________________________ ("Borrower"), promises to pay to the order of ___________________________ ("Lender"), the principal sum (the "Principal") of $_____________, plus interest at the rate of Six Percent (6%) per annum (non-compounding) from and after the date of this Note. (a) Repayment will be made in 60 equal payments of $1933.28 payable on the 1st of each month, with a Start Date of START DATE until the total debt is satisfied. (b) The entire unpaid Principal and all accrued and unpaid interest, unless previously paid in full, shall be due and payable at the Maturity Date Five (5) years from the Start Date of this Note. Borrower shall not be obligated to make any payments on the Principal or any interest accruing thereon, until the Maturity Date; however. Borrower shall have the right to prepay this Note in full or in part without penalty at any time. (c) Any payments made shall be applied first to the payment of any costs, fees or other charges incurred in connection with the indebtedness evidenced herein, next to the payment of accrued interest, and then to the reduction of the Principal. Payments shall be made by Borrower to Lender at the address set forth below.
- DEFAULT. The Borrower shall be in Default of this Note upon the happening of any of the following events or conditions, namely: if monthly payments are not received on or before the fifth day of the month, or if the entire balance of Principal and accrued interest is not paid on or before the maturity of this Note; or any breach of any covenant, warranty, liability or any other obligation contained or referred to herein, whether now, existing or hereafter arising. Notice of default shall be given by the method specified in paragraph 5.
- ACCELERATION. After the occurrence of any Default as set forth herein, then the entire amount of the unpaid principal of this Note, irrespective of the maturity date specified herein, together with the then accrued interest thereon, shall, at the election of Lender, immediately become due and payable.
- DEFAULT INTEREST RATE. In the event of a Default which is not cured within ten (10) days, the unpaid principal balance hereof shall bear interest (commencing on the date of default and continuing for so long as such default continues regardless of whether or not there has been an acceleration of the indebtedness) at the rate of __________ percent (______%) per annum in excess of the interest rate set forth above, until paid (the "Default Rate"), with such Default Rate to be compounded annually, and payable on demand.
- NOTICE. Any notice to Borrower provided for in this Note shall be given by mailing such notice by certified mail, addressed to Borrower at the address listed below, or to such other address as Borrower may designate by notice to Lender. Any notice to Lender shall be given by mailing such notice by certified mail, return receipt requested, to Lender at the address stated below, or at such other address as may have been designated by notice to Borrower. Email notification is acceptable if mutually agreed by Borrower and Lender.
- ATTORNEYS' FEES. Borrower, guarantors and all persons liable or to become liable on this Note agree to pay all costs of collection when incurred, including reasonable attorneys' fees and all costs of suit or other proceedings of collection, in case the unpaid principal sum of this Note, or any payment of interest thereof, is not paid when due, and all expenses incurred by Holder to protect the security for the indebtedness evidenced hereby, should it become necessary to do so, whether through courts of original jurisdiction, courts of appellate jurisdiction, through bankruptcy court or in other legal proceedings. No extension of time for the payment of this Note made by agreement with any person now or hereafter liable for the payment of this Note shall operate to release, discharge, modify, change or affect the original liability under this Note, either in whole or in part, of any of the undersigned not a party to such agreement.
- SUCCESSORS AND ASSIGNS; NON-ASSUMABILITY OF NOTE. Whenever used herein, the words "Borrower" and "Lender" shall be deemed to include their respective heirs, personal representatives, successors and assigns, if any. This Note shall be non-assumable, unless the other party in its sole discretion and without any obligation whatsoever to do so, gives its prior written approval. Any attempted assumption of this Note without such approval shall constitute a Default.
- APPLICABLE LAW. Except where preempted by the laws of the United States, this Note shall be construed in accordance with and governed by the laws of the State of ______________.
"Borrower" "Lender"
Name: ___________________________ ___________________________
Signature: ___________________________ ___________________________
Date: ___________________________ ___________________________
Address: ___________________________ ___________________________
___________________________ ___________________________
************* End Note **************
As mentioned in the Make It Big book loans and notes can be secured by assets in case of default. Both note examples above are unsecured. The following term could be added to secure the note.
SECURITY. Borrower agrees that until the principal and interest owed under this note are paid in full, this note will be secured by a security agreement and Uniform Commercial Code Financing statement giving Lender a security interest in the assets, equipment, inventory, intellectual property, and accounts receivable of the business known as ENTER COMPANY NAME . Borrower further agrees that until the principal and interest owed under this note are paid in full, this note will be secured by the mortgage ENTER ADDRESS AND MORTGAGE NUMBER and deed of trust covering the real estate known as __________________________________________________________.
This term specifies the security as company assets, mortgage, and deed of trust. In practice the security can be a subset of these or any other assets applicable and agreeable to both parties. Note that securing a note requires the filing of a UCC-1 form more fully described by Wikipedia here: http://en.wikipedia.org/wiki/UCC-1_financing_statement. I used a variation of the longer note above to facilitate a friends and family transaction that I consulted on. It worked well for what they wanted to do.
Hope this helps. The book "Make It Big Crossing the Entrepreneur's Gap" describes a number of financing options for entrepreneurs. Promissory Notes are just one example. Review the other financial instruments in the book. There are a number of options discussed that highlight the best instruments based on the company and investor type.
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Disclaimer: Material provided herein is for illustrative and educational purposes only. If you require the use of these or similar documents, you should seek the advice of a legal attorney.
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