One of the easiest ways to document a loan is through the use of a promissory note. Practicing here in Silicon Valley and San Jose, I have documented countless promissory notes for clients. If you are considering entering into a promissory note, whether as a lender or borrower, you should know the basic options that you have in structuring the note.
Before we delve deeper into the specifics of preparing promissory notes, one thing to keep in mind is that a promissory note is often entered into as part of a larger loan package. While some loans are just made with a simple promissory note, other loans are made with a variety of documents, which can include documents like a promissory note, loan agreement, security agreement, deed of trust, subordination agreement, guaranty, etc. While the scope of this blog is limited to promissory notes, it is important to consider all of the documents that may be needed as part of a loan, not just a promissory note. The complete set of documents required to evidence a loan are usually driven by the unique business terms of the transaction.
That said, let’s get back to the common considerations of promissory notes. Below is a breakdown of some of the common considerations that I go through with my clients before preparing a promissory note:
Timing of Payments
When will payments be made? Will they be made weekly, monthly, quarterly, annually?
Mode of Payments
Will payments be fixed or variable? Note that a large factor in this is whether the interest rate is fixed or variable.
Will payments be interest only or will they include principal as well? What will be the principal amortization schedule?
What will be the maturity date and will the note have a final, larger “balloon payment” at maturity?
Interest Rate
What will be the interest rate?
Will interest accrue annually, quarterly, monthly, daily?
Will the note be fixed or variable (as mentioned above)?
If variable, will the loan be tied to a reference rate or some other commonly used benchmark?
If the commonly used benchmark ceases to exist, is there a backup index that will be used?
Late Charges
Will a late charge be imposed? If so, will the late charge be a fixed percentage of the regular installment payment or a fixed amount?
Prepayment
Can the note be prepaid? If so, is there a penalty associated with prepayment?
Default
What is considered a default (besides just a missed payment)? What occurs upon default?
Collateral
Will there be collateral for the loan and how does this factor into the documentation?
The list above is an illustration of the type of items that a lender or borrower should consider when entering into a promissory note. This is by no means an exhaustive list and there are always numerous other factors to consider depending on the specific situation of the parties. I always recommend for people to sit down with their attorney to go over the loan concept in detail before documenting it. The less ambiguity that there is in the document, the less likely you will end up in protracted litigation trying to explain the original intent of the parties if there is ever an issue. Ideally, any document that you enter into should be detailed enough that, if necessary, a court can look at it and make a determination on the spot regarding the document without having to look at the intent of the parties – which can become very costly for both sides.
The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.
