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How To Self-Finance Your Busi­ness

One of the great­est con­cerns for any small com­pa­ny or start­up is mon­ey.  Where do you get the mon­ey to start your com­pa­ny, and where do you get mon­ey to keep your com­pa­ny going?  The three most com­mon sources of start­up cap­i­tal are 1) per­son­al sav­ings, 2) cash flows from the busi­ness, and 3) cred­it cards, as seen below in a great sketch by the Kauff­man foun­da­tion.

Giv­en these num­bers it may make sense to answer the ques­tion – how do we legal­ly self-finance our busi­ness?  The most obvi­ous answer is that we can fund the com­pa­ny when we pur­chase our own­er­ship per­cent­age in the com­pa­ny.  This ini­tial own­er­ship pur­chase, how­ev­er, may not yield sub­stan­tial funds or does not meet your company’s finan­cial needs. Two com­mon legal self-fund­ing meth­ods are a promis­so­ry note (loan) and a con­vert­ible promis­so­ry note (loan + con­ver­sion fea­ture).  We will only cov­er a promis­so­ry note here but we will briefly touch on a con­vert­ible note.

A promis­so­ry note is a loan agree­ment that allows the com­pa­ny and indi­vid­ual (be it a founder or oth­er indi­vid­ual) to record the loan and the terms under which it will be gov­erned (inter­est rate, pay­ment terms, matu­ri­ty date, etc.).  Below is a step-by-step expla­na­tion for how to enter into a promis­so­ry note with some­one loan­ing mon­ey to the com­pa­ny. We will also dis­cuss some poten­tial options for the indi­vid­ual and com­pa­ny once the mon­ey has been loaned. Pre­lim­i­nary Steps

  1.  Board Min­utes (or Mem­ber Meet­ing) Approv­ing Promis­so­ry Note
  • What is it? Typ­i­cal­ly, the Board or Mem­bers of a com­pa­ny must approve the com­pa­ny enter­ing into debt, even with a founder of the com­pa­ny.
  • What to do? Draft the Min­utes and have the Sec­re­tary or Pres­i­dent of the com­pa­ny sign them.
  1.  Exe­cute A Demand Promis­so­ry Note
  • What is it? The loan instru­ment which allows the com­pa­ny to enter into a bind­ing debt agree­ment.  Typ­i­cal terms in such an agree­ment should address the inter­est rate, pay­ment terms, and the matu­ri­ty date.
  • What to do?  Draft the promis­so­ry note, record the amount to be loaned or the por­tion that has been loaned up to that point to the com­pa­ny.  Have both par­ties sign the note. A well draft­ed promis­so­ry note for a start­up or small busi­ness just start­ing out should allow for the note hold­er (the per­son loan­ing the mon­ey) to con­tin­u­al­ly add to the amount under the note – such as if the hold­er is con­tin­u­al­ly putting charges on a cred­it card.  If the hold­er is loan­ing lump sums of cash as the com­pa­ny needs it, then they can record that as well with­out hav­ing to cre­ate a new note for each install­ment of cash. For good record keep­ing, both par­ties should keep records of the note and update it simul­ta­ne­ous­ly.
  1.  Option­al – Promis­so­ry Note For­give­ness
  • What is it? Some­times repay­ment of a loan is not in the best finan­cial inter­est of the com­pa­ny when the matu­ri­ty date of the loan comes about.  The note hold­er and the com­pa­ny can choose to extend the matu­ri­ty date of the note or for­give the note alto­geth­er.
  • When to use? Option­al.  When the note hold­er wish­es to for­give the note.  Total­ly up to the note hold­er.
  • What to do? Have the note hold­er exe­cute a loan for­give­ness agree­ment and have both par­ties sign this.  Also, for good record keep­ing, there should be a record of the loan for­give­ness in the com­pa­ny ledger.
  1.  Option­al – Use The Promis­so­ry Note To Pur­chase A Con­vert­ible Note
  • What is it? A con­vert­ible note is sim­i­lar to a loan in that the com­pa­ny can repay the prin­ci­pal and inter­est.  A con­vert­ible note, how­ev­er, also has a mech­a­nism which allows it to be con­vert­ed into stock of the com­pa­ny.  Typ­i­cal­ly this con­ver­sion is trig­gered when the com­pa­ny rais­es its first ven­ture cap­i­tal mon­ey (also know as a “qual­i­fied financ­ing”), and the prin­ci­pal and inter­est on the note is used to pur­chase shares of the stock being offered in the qual­i­fied financ­ing.  Con­vert­ible notes are well know for their use in fam­i­ly & friend or angel financ­ings. A promis­so­ry note can be used as con­sid­er­a­tion (used to pay) for a con­vert­ible note when the com­pa­ny choos­es to issue con­vert­ible notes in a fam­i­ly & friend or angel financ­ing thus allow­ing the lend­ing founder to gain equi­ty for his or her addi­tion­al financ­ing con­tri­bu­tion.
  • When to use? Option­al.  When the note hold­er wish­es to get equi­ty in exchange for his loan to the com­pa­ny.
  • What to do?  Cre­at­ing a con­vert­ible note and sub­se­quent­ly exe­cut­ing indi­vid­ual note pur­chase agree­ments will be dis­cussed in anoth­er post.  In short, the note pur­chase agree­ment which will be exchanged for the promis­so­ry note must con­tain lan­guage ref­er­enc­ing the promis­so­ry note and the total amount of prin­ci­pal and inter­est.

By Matt Faust­man

This arti­cle was orig­i­nal­ly pub­lished on UpCoun­sel.

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