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
- 1
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.
- 4
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.
- 6
For loans between family members or friends, a formal promissory note helps maintain professional boundaries and prevents misunderstandings that could damage personal relationships.
- 7
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.
West Virginia Requirements for Promissory Note
Promissory notes for amounts over $5,000 must be in writing to be enforceable under West Virginia's Statute of Frauds.
West Virginia law caps interest rates at 8% for non-consumer loans unless otherwise specified by written agreement. Exceeding legal interest rates may constitute usury.
Charging interest rates above the legal maximum may result in forfeiture of all interest and potential penalties. The note must comply with state usury laws.
To be considered a negotiable instrument, the promissory note must be in writing, signed by the maker, contain an unconditional promise to pay a fixed amount, be payable on demand or at a definite time, and be payable to order or bearer.
For consumer loans, the note must disclose key terms including APR, finance charges, amount financed, and total payments in a clear and conspicuous manner.
Prohibits discrimination against credit applicants on the basis of race, color, religion, national origin, sex, marital status, age, or because they receive public assistance.
Any acceleration clause (allowing the lender to demand full payment upon default) must be clearly stated and specify the conditions that trigger acceleration.
Any prepayment penalties must be explicitly stated in the note. West Virginia law restricts certain prepayment penalties in consumer loans.
The note must clearly define what constitutes a default and specify the consequences, including any late fees, which are limited under West Virginia law.
Confession of judgment clauses (where borrower pre-authorizes judgment upon default) are generally prohibited in consumer transactions in West Virginia.
Legal action to enforce a promissory note in West Virginia must be commenced within 6 years for notes under seal and 10 years for negotiable instruments.
Electronic signatures are valid for promissory notes under both federal and West Virginia law, provided they comply with applicable requirements.
Provisions for recovery of attorney's fees in case of default must be reciprocal, allowing either party to recover fees if they prevail in litigation.
The note should specify which state's law governs the agreement. West Virginia courts generally enforce choice of law provisions if there is a reasonable relationship to the chosen state.
If the note is secured by collateral, it must comply with Article 9 of the UCC as adopted in West Virginia, including proper description of collateral.
For consumer loans, the note must comply with West Virginia Consumer Credit and Protection Act, which provides additional protections beyond federal requirements.
Any provisions attempting to restrict the borrower's right to file for bankruptcy protection are unenforceable under federal law.
If multiple borrowers sign the note, the note should clearly state whether liability is joint, several, or joint and several under West Virginia law.
Any waiver of borrower's defenses must comply with West Virginia law, which limits such waivers, particularly in consumer transactions.
The note must specify how and where notices between parties are to be delivered, consistent with West Virginia's requirements for legal notices.
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.