What’s with All this Paperwork VII: Promissory Note (Balloon Payment)

Hey everyone, it’s amazing, it’s already December 2012 and it feels like January 2012 was just yesterday.  Anyway, I just wanted to let you know that this is second to last Draw the Law of this year.  There will be one more, continuing the paperwork theme that I have explored for startup owners for the past couple of months.  After which I will do a couple of sporadic updates to the blog and site to continue being a resource for Hawaii small business owners and entrepreneurs. So let’s get to it! So you started your business, now you need cash to run it.  Several earlier Draw the Laws talked about raising capital and financing your startup.  However, today’s topic is specifically about one of the written agreements that you may want to use.  It is a Promissory Note that uses the Balloon Payment method.

What is a Promissory Note?

Without getting too much in legalese (which I will save for another day) know that a promissory note is a type of negotiable instrument.  A negotiable instrument is a document that promises payment to a specific person.  If you don’t use Paypal or your banking debit card to pay off expenses, you are familiar with a more common negotiable instrument, a check.

For a document to be a promissory note it is dated and signed.  Further, it contains an unconditional promise by the payor to a payee on demand or at a specified future date.  What is a payor and payee?  Click here to find out for the legalese explanation.

For our purposes in this post, know that the payor is the person who is going to pay the payee the money owed.  Put another way, the payor is the person who asked for the loan and then will pay the payee, or the person who made the loan.

Why do I Need this Written Document?

For a promissory note to be valid, notice it has to be signed, thus you need it in writing.  Onto the practical matter, many times people switching out of their careers to pursuit their own business do not have enough cash for equipment or other upfront expensive items.  Therefore, they need a loan.

A bank might not give them credit and the startup owner may be an area that is not Silicon Valley or sufficiently networked to get an investor.  Therefore, they turn to Auntie or Tutu for money.  However, your family member (or friend) may be wary of you repaying the loan and wants to get in writing.  Ignoring the legal part, the effect of memorializing the loan in writing also gives you a metric to measure your business by . . . basically, if you are failing to meet monthly payments to your relative that might say something about your business.

What is a Balloon Payment?

A balloon payment is a way of structuring a loan so that the monthly payments are on the low end and toward the end term of the loan, the payor makes a one big lump-sum payment to pay off the remaining principal.

To understand this concept, let’s start off without the balloon payment.  Let’s say both parties agree that the full amount of the loan, plus interest, shall be paid off in four years.  However, the yearly rate of 8% interest would make it unfeasible for a business just starting to make monthly payments based on that rate scheduled at four years.

So with the balloon payment you reduce the yearly rate to 4% (which would be under a loan over an eight-period), which helps ease the monthly payments, BUT the payor still has to pay the remaining amount within 4 years, but the last payment has “ballooned” due to the reduced monthly payments.

Last Word: Drafting

While, it is possible to draft your own promissory note, and possibly in very causal relationships that might be ok there are other things to consider other than the amount, interest rate, and ending date that an attorney might be helpful for drafting. For example, the date of the installment payments, application of payments, accepting prepayment, loan acceleration, taking a security or collateral, and of course what happens if they fail to make payment.  In addition, you may want to talk to a tax expert because that also may shape the loan and repayment.

*Disclaimer:  This post discusses general legal issues, but does not constitute legal advice in any respect.  No reader should act or refrain from acting based on information contained herein without seeking the advice of counsel in the relevant jurisdiction.  Ryan K. Hew, Attorney At Law, LLLC expressly disclaims all liability in respect to any actions taken or not taken based on the contents of this post.