Promissory Notes, SAFE Notes, Convertible Notes and Debt Financing
There are a number of ways to use debt to finance a business or start-up. Common debt instruments include things like convertible notes and promissory notes. Below is a brief explanation of the differences.
Promissory Note: a promissory note for a business or start-up is very much like a loan in the traditional sense. It has an interest rate, a term (length) for repayment and consequences for default. If Uncle Joe wants to loan you $10,000 for your business, your business or start-up would sign a promissory note to repay Uncle Joe. There are tax consequences for both the investor and the business owner on promissory notes and their interest, so it’s wise to also check with an accountant on the structure. Sometimes one of the start-up’s founders will loan the business money. Even though the loan is from a founder, a promissory note with formal terms should be executed. Again, there are tax consequences to this, so make sure to have the note reviewed.
Convertible Notes: convertible notes are promissory notes that could also convert to equity in the business upon a certain event occurring. A convertible note will also be for a specified term and at a specific interest rate. If the note is not repaid within that time frame, it converts to equity. Many founders like convertible notes because it’s like they don’t mentally have to deal with repayment for some time. They can kick the can down the road, so to speak. However, this can be a dangerous attitude as those notes come due much sooner than you might realize and before there might be positive cash flow. Also exercise caution in who you issue convertible notes to. If there’s a conversion to equity, that person is now a new business partner and you should be sure it’s someone you want to have in your business.
If you need help drafting a promissory note or convertible note for your business, please contact our office for help.