Promissory Note Guide for Small Business Owners: What You Need to Know
Comprehensive guide to understanding promissory notes for small business financing, with essential information for MWBEs, established businesses seeking expansion, and first-time business owners.
Introduction
A promissory note is a legally binding document that formalizes a loan agreement between a borrower and a lender. For small business owners, particularly minority and women business owners (MWBEs), established businesses seeking expansion capital, and first-time entrepreneurs, understanding promissory notes is crucial when securing financing. This document serves as written evidence of debt and outlines the terms of repayment, including the principal amount, interest rate, payment schedule, and consequences of default. Whether you're obtaining funding from a bank, alternative lender, friend, family member, or investor, a properly structured promissory note protects both parties and creates clarity around the borrowing arrangement.
Key Things to Know
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Always have an attorney review your promissory note before signing, especially for significant business loans. The small cost of legal review can prevent costly mistakes.
- 2
Keep detailed records of all payments made against the promissory note, including dates, amounts, and confirmation numbers.
- 3
Understand the difference between recourse and non-recourse loans in promissory notes. Non-recourse limits the lender to collecting the collateral only, while recourse allows them to pursue other assets if the collateral value is insufficient.
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If interest rates are variable, make sure the note clearly specifies how and when rates can change, and consider negotiating a cap on how high the rate can go.
- 5
Be aware that promissory notes can sometimes be sold or transferred to other lenders, which could affect your relationship with the debt holder.
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For loans between family members or friends, a formal promissory note helps maintain professional boundaries and prevents misunderstandings that could damage personal relationships.
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Consider including a cure period in your promissory note that gives you time to remedy a missed payment before being considered in default.
- 8
Understand the tax implications of your promissory note, as interest paid on business loans is generally tax-deductible, but there may be other considerations depending on your situation.
Key Decisions
Promissory Note Requirements
Full legal name, address, and contact information of the individual or entity providing the loan.
Full legal name, address, and contact information of the individual or entity receiving the loan. For businesses, include the legal business name, entity type, and EIN.
South Dakota Requirements for Promissory Note
South Dakota law sets maximum interest rates that can be charged on loans. For written agreements, the maximum rate is set by statute, with different limits for different types of loans. The note must comply with these limits to avoid being deemed usurious.
The note must acknowledge the statute of limitations for enforcement of promissory notes in South Dakota, which is 6 years for written contracts.
For consumer loans, the note must comply with federal Truth in Lending Act requirements, including clear disclosure of APR, finance charges, amount financed, and total payments.
The note should specify any late payment fees, which must be reasonable and not constitute a penalty under South Dakota law.
South Dakota law permits acceleration clauses that allow the lender to demand full payment if the borrower defaults, but the note must clearly state this provision.
The note must specify whether the borrower has the right to prepay the loan without penalty, as South Dakota law generally permits prepayment of loans.
The note and underlying loan process must comply with federal prohibitions against discrimination on the basis of race, color, religion, national origin, sex, marital status, age, or receipt of public assistance.
South Dakota law permits provisions for reasonable attorney's fees in the event of default and collection actions, but the note must explicitly include this provision.
The note should specify that South Dakota law governs the agreement, particularly important if parties are from different states.
To be negotiable under South Dakota law (which follows the UCC), the note must contain an unconditional promise to pay a fixed amount of money, be payable on demand or at a definite time, and be payable to order or bearer.
The note must clearly define what constitutes a default and the consequences thereof, in accordance with South Dakota contract law.
If the note is secured by collateral, it must comply with South Dakota's adoption of UCC Article 9 regarding security interests, including proper description of collateral.
The note may be signed electronically under both federal and South Dakota law, but must comply with requirements for electronic records and signatures.
The note may include a waiver of presentment, protest, and notice of dishonor as permitted under South Dakota's adoption of the UCC.
If multiple borrowers are involved, the note should specify whether liability is joint and several, as recognized under South Dakota law.
South Dakota law permits confession of judgment clauses in certain commercial contexts, but the note must comply with specific statutory requirements if including such a provision.
The note must specify how and where notices between parties are to be delivered, in compliance with South Dakota contract law requirements for notice.
The note should include a severability clause stating that if any provision is found invalid under South Dakota law, the remainder of the agreement remains enforceable.
The note should specify whether the lender has the right to assign the note to third parties, as permitted under South Dakota's adoption of the UCC.
For borrowers who are active duty service members or their dependents, the note must comply with federal limitations on interest rates and other terms.
Frequently Asked Questions
A promissory note is a written promise to repay a specific sum of money to a lender under defined terms. As a business owner, you need one because it: 1) Formalizes the loan agreement, 2) Clearly documents the amount borrowed, interest rate, and repayment schedule, 3) Provides legal protection for both borrower and lender, 4) May be required by financial institutions or investors, and 5) Creates accountability and structure for repayment. Without a proper promissory note, misunderstandings can arise about loan terms, potentially damaging business relationships and creating legal complications.
A comprehensive promissory note should include: 1) Names and contact information of all parties involved, 2) The principal amount being borrowed, 3) Interest rate and how it's calculated (simple or compound), 4) Repayment terms (payment amounts, frequency, and due dates), 5) Maturity date (when the loan must be fully repaid), 6) Any collateral securing the loan, 7) Default provisions and consequences, 8) Prepayment options or penalties, 9) Signatures of all parties, and 10) Date of execution. For business loans, you may also want to include covenants regarding business operations or financial reporting requirements.
As an MWBE, consider these specific aspects when dealing with promissory notes: 1) Some MWBE loan programs offer more favorable terms, so ensure these are accurately reflected in your note, 2) If using an MWBE-specific lender or program, the note may contain special provisions related to certification maintenance, 3) Document any preferential interest rates or terms you've negotiated based on your MWBE status, 4) Consider including language that addresses what happens if your MWBE certification status changes, and 5) Be aware that some MWBE financing programs may have additional reporting requirements that should be referenced in the note. Always consult with an attorney familiar with MWBE financing to review your promissory note.
Secured promissory notes are backed by collateral (business assets, equipment, real estate, etc.) that the lender can claim if you default. Unsecured notes have no collateral requirement. The better option depends on your situation: Secured notes typically offer lower interest rates and better terms because they're less risky for lenders, but you risk losing the pledged assets if you default. Unsecured notes don't put specific assets at risk but generally come with higher interest rates and may be harder to obtain, especially for new businesses with limited credit history. Consider your business's asset position, risk tolerance, and the loan terms when deciding. Established businesses with valuable assets might benefit from secured notes, while businesses without significant assets may need to use unsecured options.
Defaulting on a promissory note can have serious consequences: 1) The entire loan balance may become immediately due (acceleration clause), 2) Late fees and penalty interest rates may be applied, 3) The lender can pursue legal action to collect the debt, 4) If the note is secured, the lender can seize the collateral, 5) Your business and personal credit scores may be severely damaged, 6) The lender might obtain a judgment allowing them to garnish business accounts or place liens on property, 7) For personal guarantees, your personal assets could be at risk, and 8) Future financing options may be limited or more expensive. To avoid these outcomes, communicate proactively with your lender if you anticipate payment difficulties, as many lenders prefer to negotiate modified terms rather than pursue default remedies.
Personal guarantees on business promissory notes require careful consideration. When you personally guarantee a business loan, you become liable for repayment if your business cannot pay. For first-time business owners, personal guarantees are often unavoidable as lenders want additional security. For established businesses seeking expansion capital, your negotiating power depends on your business's financial strength and credit history. Consider: 1) Your business's ability to repay the loan from cash flow, 2) Your personal financial situation and risk tolerance, 3) Whether you can negotiate a limited personal guarantee (capped at a certain amount or percentage), 4) The possibility of multiple owners each providing limited guarantees, and 5) Whether the loan terms justify the personal risk. Consult with a financial advisor and attorney before signing any personal guarantee.
To negotiate better promissory note terms: 1) Improve your business credit score and financial statements before applying, 2) Shop around with multiple lenders to compare offers, 3) Highlight your business strengths, stable cash flow, and growth potential, 4) Consider offering collateral to secure lower interest rates, 5) Negotiate the interest rate, repayment schedule, and prepayment penalties, 6) Ask for an interest-only period at the beginning of the loan term, 7) Request a longer maturity date to reduce monthly payment amounts, 8) Negotiate caps on variable interest rates, 9) Limit or eliminate personal guarantees if possible, and 10) Work with a financial advisor or attorney who specializes in business financing. MWBEs should also inquire about special programs designed for their businesses that may offer preferential terms.
While related, promissory notes and loan agreements serve different purposes: A promissory note is a shorter document that primarily functions as evidence of debt and a promise to repay. It focuses on the essential terms: amount borrowed, interest rate, payment schedule, and maturity date. A loan agreement is more comprehensive and details the broader relationship between borrower and lender, including representations and warranties, covenants (ongoing obligations), conditions for disbursement, reporting requirements, and detailed default provisions. For simple loans between individuals or small amounts, a promissory note may be sufficient. For complex business financing, you'll likely need both documents—the loan agreement governing the overall relationship and the promissory note serving as the actual debt instrument. Many small business loans use both documents together.