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Formalizing the arrangement in a promissory note provides you with the opportunity to analyze your farm’s financials and determine how much you really need over a set period of time. For example, if you’re borrowing money to purchase farmland, do you need the full amount, just the down payment, or only part of the down payment?
Like any small business owner, a farmer should strive to not to take on too much debt. At the same time, she needs to be sure she won’t run into cash flow issues when paying bills, making payroll, and having enough left over to pay for capital expenditures and unexpected costs such as repairs on a month-to-month basis, including during the off season. This can be a challenging balancing act. However, these are all important things to consider when determining how much money to borrow. By taking the time to diligently figure out precisely–or at least close to–what you actually need, you’ll help build a sense of respect and trust with your lender. No one likes to be the one who’s constantly being asked for more money. Likewise, no one likes to be asked for more money than what’s actually needed.
Whatever amount is decided and agreed to will need to be set forth in the promissory note. The actual amount being borrowed is called the “principal.”
The borrower is often referred to as the “Maker” in the promissory note. There are a couple of key issues to consider here.
If the farm operation has a formal business entity, such as an LLC or a C corporation, then it’s best to have the entity named as the borrowing party on the promissory note. This is because to protect and maintain the integrity of the business entity, it’s essential to keep the business’ financial matters–including debts–separate from the financial matters of the owners. In addition, this provides added assurance to the friend or family member who’s lending the money that the individual won’t instead cash the check to fund her holiday vacation! If you don’t have a business entity, then the borrowing party in the promissory note would be the individual(s) involved in the farm business.
With that said, loans to business entities can raise a high degree of suspicion that the financial transaction falls within the legal definition of a security–or an investment in a company for an expected return on profit. Loans to individuals raise less suspicion, but it can still be an issue. Be sure to review the section on security law issues at the end of this guide–Is my promissory note a security and why does it matter? This section explains why and how to avoid your promissory note being deemed a security.
If there are multiple individuals involved in your farm operation – whether a married couple, a formal general partnership, or a casual venture between multiple farmers – it’s up to you to decide whether just one, some, or all will be named on the promissory note. The person(s) named will be on the hook for making the payments on time. If they default or miss a payment, they could be sued. Nevertheless, even if a partner is not formally named on the promissory note, a court could still conclude that she is on responsible. This is because under certain circumstances a court could find that a couple or more farmers who work together consistently to achieve a shared purpose may cross the line into forming a general partnership, even if they didn’t officially try. If this happens, then all of the individuals involved are jointly and severally liable for any promises or commitments that any one of the others makes. This can include a situation where one partner enters a loan arrangement with a promissory note. The others may be on the hook even if their name is not on it. The key here is that if you are taking out a loan to work on a project with other farmers, or you are working with a farmer that is taking out a loan to work on a project with you, be sure you work together to negotiate the terms of the arrangement. And be aware that you or others may be responsible even if your or their name is not formally listed as a party on the promissory note.
The lender is the person offering the money and is often referred to as the “Holder ”in the promissory note. One key thing to consider here is whether the lender needs to be concerned about a potential gift tax. The gift tax applies if someone gives money or something of value (i.e. real property such as land or a house or personal property such as equipment, tractors, computers, etc.) to someone else and in return the giver receive nothing or less than full value of what was given. While it may be tempting for a friend or family member to offer an interest-free loan, or even not require the full payment in return, the IRS will deem these situations a gift that may subject the lender to a hefty gift tax.
Note that there are some key exclusions to the gift tax. To learn about exclusions and more about the gift tax, see the special legal section What’s the difference between a gift and a loan and why does it matter?
The parties will need to negotiate whether interest will be charged. If so, what will be the rate? And, at what interval will interest rates be calculated, monthly, annually, or by another interval? Interest rate accrual calculators are available online, which can be useful to figure out how much interest will add up over the period of the loan. Simply search “interest rate calculator.” As further explained in section 5 of this guide, to protect the lender from being subject to a gift tax, the promissory note should require interest charges at or above the latest minimum IRS-set interest rate.
The length of the loan is significant to the lender; he will want to know by when he’ll get his full payment back. It is also significant to the borrower; she’ll need to figure out by when she can actually come up with the money. The borrower must be sure not to overcommit to a short time frame, as this could really get them in a bind. A better option may be to stretch the commitment out longer, and then provide the option to pay in full early, if and when you can. However, the longer you stretch it out, the more interest will accrue. These numbers can be alarming at first glance. In our example, Susie (on behalf of Mother Earth Farms LLC) takes out a loan from her brother Danny for $20,000 for a three-year term at three-percent interest per year. The LLC will end up paying a total of $21,224.16 over the course of the loan–$20,000 in principle and $1,224.16 in interest. If it were stretched out longer, interest charges would be even higher.
Determining the ideal timeline for paying a loan off can be a challenging balancing act. Solid financial planning, including putting together a monthly cash flow analysis, is essential for determining when and whether you can make the payments when due.
The parties have quite a bit of flexibility to decide how the repayments will be made. Examples include installment payments, lump sum payments, in-kind payments, or a combination of two or more. We’ll discuss each of these a bit. Installments are interval payments such once a month, semi-annually, once a year, and so on. This may be a good option for farms that have consistent cash flow and/or want to spread their payments out evenly. A lump sum payment is a one-time payment at the end of the loan term. This may be good for farmers that are starting out and want to retain cash flow early on to get things going. However, it is risky as things may go south and regardless of what happens, you’ll have to come up with the money all at once. To address this, you could have a combination of installments and then a larger lump sum payment at the end. This would allow the amount to be spread out, and because there’s a lump sum at the end, the installments will be less than if it were all equal installments. The parties would need to negotiate how much the lump sum would be, as well as how much the installments are–these amounts would need to be based on both the principal amount of the loan and any interest charges.
Another option is to pay in-kind, which is calculated in the value of products or services. In-kind payment could include any farm product of value such as CSA shares, produce, value added-products etc. If you choose this route, be sure to agree on a clear mechanism for calculating the value of the product and include this in the promissory note so everyone is clear on the terms. Is it the going rate at the farmer’s market that year? The going rate at the grocery store? Or another specified amount? You’ll also have to assess what’s practical. Likely the lender won’t want $20,000 in cheese, and, even if so, the farmer may not be able to follow through on such a large quantity. One way to get around this is to require that some of the payments be in cash (whether in installments or a lump sum) and others in-kind.
The sample promissory note that follows provides sample provisions for of these options and other ideas to help you craft an ideal repayment plan for your situation.
Early payments in full or in part are considered prepayments. Sometimes lenders like to charge prepayment fees or penalties or even outright prohibit prepayment. This is typically because if the lender gets a large chunk of money all at once, it could increase his tax basis. Lenders also often want to count on the maximum benefit or “return on investment” of interest charges over the full course of the loan. If a borrower pays off the loan early, less interest will accrue. Basically, prepayment penalties or fees favor the lender and are quite unfavorable for the borrower. In our example, if Susie or Mother Earth LLC comes up with the money early on, she would be stuck paying the interest charges or incurring a prepayment fee. Farmers should be wary of prepayment fees or prohibitions and try to negotiate the option to make early payments without any charge or trouble.
If the borrower fails to make a payment when due, it is referred to as a “default” on the loan. While this is a touchy subject, especially between friends and family, this is one of the most important aspects of the promissory note. Anything can happen, and it’s best to address the tough issues and worse case scenarios up front so the parties all know what to expect and the issue can be resolved smoothly. The parties have several options.
One thing to consider is whether to charge penalties or fees for late payments. For example, you could charge a fee of 5% if the borrower does not make a payment by the 10th day after it is due–or even on the day it’s due. The late fee could increase as the payment is later or later. This is just one option to incentivize borrowers to pay on time.
Often promissory notes have what’s called an acceleration clause, which says that if the borrower defaults and fails to pay by a certain time then the lender can ask for the entire amount due immediately. If the borrower doesn’t pay up, the lender can take the borrower to court to get a judgment for the rest of the money. Typically, the acceleration requires the lender to initiate the acceleration clause upon the borrower’s default. If the lender decides not to do so out of kindness or something else, then the contract goes on as normal.
A loan is either secured (collateral is attached) or unsecured (no collateral is attached). Collateral is anything of value that the borrower owns that can be taken by the lender if the borrower cannot afford to pay back the loan. In effect, it offers the lender another layer of security to ensure that she will get her money back. Examples of collateral include real property (i.e. farmland or houses) and personal property (i.e. anything other than land such as cars, farm equipment, computers, etc.). If the lender requires collateral, the lender has what’s considered a security interest in the collateral until the loan is paid off. This security interest is basically a right to seize the property if the borrower is in default or the loan is not paid off. In our example, the collateral attached to the loan is a piece of farmland. If Susie (on behalf of Mother Earth Farms LLC) defaults, her brother Daniel could foreclose on the property to recover the balance owed on the loan. Any remainder from the proceeds of the sale of the land would go back to Mother Earth Farms LLC. If a promissory note is unsecured (no collateral is attached), then the lender’s only recourse is to go through the normal debt collection process in court.
One benefit of the secured loan is that it will help assure that your promissory note will not be deemed a “security” that is subject to federal and state securities laws. For more on this, read section 6: Is your promissory note a security and why does it matter? But, note that having a secured loan can add another layer of complexity. For a secured loan, the promissory note will need to provide an adequate description of what the collateral is so there’s no question or dispute down the road. The parties may also decide to enter a separate security agreement which will specify in greater detail the asset given as collateral and what action the lender can take to seize the property upon default. In addition, while not legally required, lenders often take an additional step when business assets are pledged as collateral for a loan. If it is personal property (i.e. anything other than real estate), lenders would file a standard UCC (Uniform Commercial Code) form with the state where the collateral is located. The standardized form used in all states is commonly referred to as the “UCC-1.” This is called “perfecting” the interest. It basically lets the public know that the lender has a legal interest in the collateral and will be first in line against other creditors that may also have an interest in it. If the collateral is real property, the lender would need to prepare and file a deed or trust, mortgage, or other required document with the recording office in the county where the real property is located in order to formalize the lender’s interest in the property.
All of these are steps traditionally taken by institutional banks and other professional lenders of commercial loans to businesses. They are not necessary for loans between family and friends. However, if your family member or friend that is lending you money has any concern about repayment, these are some of the actions he or she may want to take to protect him or herself.
Keep in mind that using a promissory note and security agreements can restrict your ability to obtain additional financing for your business, especially if the lender files a UCC-1. Institutional banks or other savvy investors may be unwilling to lend funds to the farm operation knowing another lender has priority in your business property.
There is no right or wrong way to go about this process. What we’ve presented here are all just things to consider and negotiate based on the needs of the lender, the relationship between the borrower and the lender, and the financial circumstances of the farm operation.
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