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
- The company is properly formed – See Choosing Your Startup’s Legal Entity and How To Form a Delaware Corporation.
- 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.
- 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.
- Example Document: Sample Demand Promissory Note
- 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.
- Example Document: Sample Note Forgiveness Agreement
- 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.
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