The siren song of entrepreneurship calls out to people following their dream of owning a business. But whether it's large or small, a start-up or long-established, a business in need of funds for equipment, salaries or other costs has an important decision to make: how to borrow the money. There are several different ways to raise money and negotiate repayment terms with lenders.
A note payable, also known as a promissory note, is a written pledge to repay a loan. It's a simple document that lists the interest rate and repayment terms that you agree to with the lender. The lender does not get any shares in your company, or any claim to your business income. To get better terms, you can pledge collateral -- property the lender can seize if you fail to repay. These "secured" loans will allow you to borrow money for a lower cost.
A note payable offers several advantages to your company. You can fit the repayment schedule to your expected income. If the note is repaid over a period longer than a year, then you deduct the interest expense from your income for tax purposes. The ability to negotiate a note payable gives you more flexibility when you raise money. For one thing, you don't need to get the approval of shareholders, if you're running a public company. For another, you can take as long as necessary to repay the loan -- terms can be re-negotiated, if necessary, between you and the lender.
If you need flexible borrowing terms, you can also apply for a term loan. This is money lent for a fixed period of time, and with a fixed schedule for repayments. The interest rate can be fixed or variable; interest rates on notes payable are generally fixed. Term loans are usually repaid over a period of one to five years. The bank or lender can change the interest rate depending on the market, using a widely watched rate such as the federal funds rate, for example, as the benchmark.
Term Loan Pros and Cons
Like notes payable, term loans offer flexible terms to small businesses. The bank may require collateral, or restrict you from taking on any further debt. Some term loans also give the lender a claim on a portion of your business income for repayment. Balloon payments of principle at the end of term loans or notes payable can put you in a bind if the funds aren't available. The lender might renegotiate the loan, or declare the loan to be in default and seize any pledged collateral.
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- What Is Unlevered Equity?
- What Is an Interest-Bearing Note Payable?