What You Need to Know About Using Promissory Notes for Startups
Entities, especially startups, need funds to pursue their business goals, reach more customers, enter new markets, expand existing markets. The not-so-pleasant side is that the funds required are not always available. So, startups might have to seek funding from other sources, hence, promissory notes.
On the other hand, promissory notes are helpful for startups when they have to lend to or borrow from other entities. In this blog post, we shall discuss what a promissory note is, its types, and its benefits. To wrap it up, we shall discuss some disadvantages of using promissory notes.
What is a Promissory Note?
A promissory note is a legal document that binds a creditor and a debtor. It can be referred to as a financial contract between two entities – the lender and the borrower. The contract specifies the details of a loan. The details include the loan amount, conditions for repayment, monthly installment, and the number of refunds. The note also contains interest rates (according to usury laws if applicable), requirements for collateral, and penalties (for nonpayment or delays). It also includes the condition for extending loan payment or discharge.
In addition, it is essential to include both the name of the creditor & borrower and the date on the promissory note. The co-signers name should be included (if there’s one). The parties (lender, borrower, and co-signer) involved in the loan transaction should share copies of the promissory note and have their signatures appended to it.
What Types of Promissory Notes are There?
- Informal Promissory Note
This promissory note is used between individuals who share a close relationship. It is otherwise known as a personal promissory note. Unlike a formal promissory note, it does not include many payment conditions or particular details. Suppose a mother has to lend her daughter some money to fly across the country for an important meeting. It would be unnecessary to ask for a co-signer or collateral. Even if there are conditions for repayment, they will be less stringent. Likewise, there would be no severe penalty for defaulting payment.
- Corporate Credit Promissory Note
A corporate credit promissory note is a formal promissory note. It attracts a higher interest rate and is often registered with the government. Startups can use this promissory note type to replace payments, for example. Let’s say your startup needs money to finalize its product development process. It might borrow the necessary funds from the bank. You can ask the bank for a promissory note stating that you will begin repayment as soon as you start making sales.
- Commercial Promissory Note
Commercial lenders such as banks and credit unions often issue this note to borrowers. It is issued for business loans (including for startups), auto loans, and loans for personal matters. Like other loans, the promissory note for this type specifies that borrowers can repay in installments.
However, when a borrower defaults in making an installment, the commercial lender can request the whole loan at once. Let’s say you borrow $10,000 from a commercial lender. If you fail to make an installment in due time, the note holder can demand the full payment instead of the installment you missed. This condition is usually stated in the note.
- Investment Promissory Note
This note type is issued to corporate bodies and investors who have the financial capacity to buy a note and manage the risks involved. So, when investors pour a certain amount into a business or startup, they get investment promissory notes.
- Student Loan Promissory Note
Students take loans to sponsor their education. They could get a promissory note and sign each time they get a loan. On the other hand, they could sign a master promissory note. The master promissory note requires the student borrower to sign only once while they receive multiple loans. The note usually stipulates the rights and responsibilities of the borrowers. It also outlines the terms and conditions of the loan. A student loan only begins to accumulate interest when the borrower graduates.
What are the Benefits of Using Promissory Notes for Startups?
Using promissory notes allows borrowers to receive loans from specific individuals or businesses that are financially capable. This means that borrowers are not limited to borrowing from banks.
Credit scores can influence the possibility of getting a loan. You can still secure a loan if you have a poor credit score. So, in the case of borrowing using a promissory note, this score matters less as you can get a co-signer with an excellent credit rating. Having a co-signer can benefit the noteholder too. When a co-signer is involved, the lender gets assurance that the borrower will repay the loan. Likewise, they can make repayments when borrowers default.
In addition, as a note holder, you can profit from lending. Instead of letting your money sit in the bank, the interest rate on the debt can bring you profit. Also, you are under no compulsion to wait till the borrower pays up to use the money, as you can borrow against the note.
A promissory note serves as evidence to confirm a financial agreement between two parties. You can tender it in court if any issues arise concerning the payment.
What are the Drawbacks of Using Promissory Notes for Startups?
If you get a loan with a bad credit score, you have to pay a higher interest. There will be issues if you default on making an installment. In the case of a commercial loan, the lender could request a lump sum repayment when you miss an installment.
Also, it might be impossible to agree with the lender to adjust specific details on the promissory note. When this happens, and you default on an installment, it could lead to a court case.
Key Takeaways:
- A promissory note is a financial contract between a lender, a borrower, and in some cases, with a co-signer.
- Details on a promissory note include the names of the lender, borrower, co-signer, date of issue, the amount owed, frequency and amount of installment, interest rate, etc.
- Types of promissory notes are; informal, corporate credit, commercial, investment, and student loans.
- One of the benefits of a promissory note for a borrower is the ability to borrow despite a poor credit score. A lender can also profit from the principal amount’s interest.
- The disadvantages of using a promissory note include paying higher interest and the inability to get the lender to adjust the note.
A promissory note is important for a lender to get money across to a borrower. It comes in different types and offers several benefits. However, it has some drawbacks. If you do not have access to funds from a lender to grow your startup or do not want to borrow, we can help you. We will give your startup the capital to grow and actualize its plans. Reach out to us today, and let’s get you the capital you need.
