Fund a Business with Promissory Notes - Explained
How to Use Promissory Notes to Fund a Business
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What is a Promissory Notes?
Any commercial loan will require a debt instrument (known as a promissory note) evidencing the debt and outlining the obligations of the borrower to repay the funds. These documents will generally include all relevant terms of the lending relationship, including interest rate and repayment schedule. As previously mentioned, debt relationships between friends and family should also employ a promissory note. This adds formality to the relationship that aids in setting the expectations of all parties. Further, the promissory note is the best way to memorialize the creditor-debtor relationship for tax purposes.
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Repayment Schedules of the Promissory Note
Repayment structures on a promissory note may vary considerably. Below are explanations of basic repayment structures used in the promissory note:
- Amortized Payments: Most business loans amortize over the life of the lone. That is, you will make equal payments at set intervals (usually monthly) throughout the life of the loan. Some portion of the loan payment will equal interest and the rest will pay toward principal. Early in the life of the loan, a high percentage of the loan constitutes interest and a small portion is applied to principle. As the principle balance diminishes a greater portion of the loan becomes principle and small portion is attributed to interest.
- Fixed (Single Payment) Repayment Date: Some loans, such a certain types of bridge loans, are structured to be paid off in a single payment. At some specific time as indicated in the note, the borrower is obligated to repay the loan in full. These are normally short-term loans that are repaid by refinancing or consolidating the loan with other outstanding debts. These types of loans are very common in leveraged buy-outs or company acquisitions. Basically, the loan is issued at a given interest rate and pursuant to an origination fee. The origination fee is the primary source of compensation to the lender.
- Note: Sometimes a borrower will simply decide to pay off an existing debt. In some promissory notes, there will be a prepayment penalty if the borrower repays the note prior to its maturity date.
- Scheduled Amortized Payments with a Final Balloon Payment: This repayment structure provides for amortized payments for a specific amount of time. Unlike fully amortized payments, however, the time period does not provide for the full repayment of the loan. As such, at the end of the repayment term, the borrower must make a single payment (balloon payment) paying off the remainder of the debt. While this form of loan provides for reduced recurring payments, the balloon payment can cause serious issues for the business. Often, the balloon payment is paid through refinancing of the debt. This incurs an additional origination fee charged by the refinancing lender.
- Scheduled Interest-only Payments with a Final Balloon Payment: This types of structure requires the borrower to make scheduled payments for a specific period with a single balloon payment repaying the entire debt at some point in the future. The payments made under this structure only constitute interest and no principle. This allow the lender to collect interest on the full amount of the loan throughout the duration of the loan. This form of loan generally has the lowest recurring payment terms, but has a very high balloon payment.