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Hey everyone, pardon the delay for this week’s Draw the Law, but many of my clients have been requesting services preparing for the end of the year or getting ready for the coming year.  How about yourself? Do you have New Year resolutions concerning the conduct of your business? Better policies? New agreements? Finally, converting that sole proprietorship into a business entity like a limited liability company or corporation?
Whatever it may be, just remember you will inevitably need good documentation and record keeping, so be sure to set-up a good process for storing all your data and information.

Anyway, let’s get back to Draw the Law, which we are still covering paperwork you may see starting a business.  Last week, I covered a promissory note with a balloon payment type of structure.  Recall, that this is a transaction whereby the loan is paid off by making small  payments throughout the term of the note, but has a large “balloon” payment in the end of the term. Today’s topic is still about loans, but this one focuses on the use of a security interest.  This method is used to provide greater assurances to a lender by providing collateral from the debtor.

So How does this Work?

Typically, a promissory note shall state that there is a secured interest in the promissory note.  It will state who the lender is, the personal property items that a security interest is attached to, and the borrower’s business. In addition, the promissory note commercial lenders, such as banks will prepare additional documentation, usually a security agreement.  If this is an agreement between you and a friend, family, or some other person you and the lender will need follow up on these details.

The security agreement outlines that grantor (the debtor) has assigned a security interest to the grantee (the lender in the transaction) with respect some sort of collateral (the personal property that is being secured for the loan).

Typically what happens is if your business goes under and is unable to repay the loan, the lender now has the right to recover the collateral as a means to satisfy the debt.

So the debtor (black) will put up some kind of collateral (the machine) for a loan (black agreement) for money (in green).  However, if repayment fails (in black) the lender (the bank) has a security agreement (in red) securing the collateral. Further, the lender will notify the public of its secured interest in the machine by filing a UCC-1 statement with the proper agency (in blue).

What Works as Collateral?

Almost anything can work as collateral.  It can be tangible items, such as equipment, fixtures, inventory, but can also be intangibles, such as accounts receivables, patents, or promissory notes owed to you.  However, be aware that the lender will consider the cost and expenses of trying to collect the item, its value after use, the size of the loan, etc . . . and various other factors when even deciding if your collateral is sufficient for the size of the loan.  The special machine you imported from Italy may cost you a huge chunk of money, but if you go out of business the bank will have to find a buyer and may have to rip it out of your store as well so that may not be worth a whole lot to the bank.

When going for a secured transaction (a loan with a security interest) be aware of what you are putting up as collateral.  It may be valuable to you, but the lender giving you money needs to figure out how to extract value from the personal property should you go under to recoup the loan given to you.

Further Documentation by the Lender: The UCC-1

This whole process of securing a loan via a security interest is basically a method for the lender to secure their spot among creditors and know for certainty if your business fails where they are in line against other creditors as to extracting value from the defunct business.  Without getting into a subject matter that law students dread studying for the bar exam, understand that a UCC-1 financing statement (UCC stands for Uniform Commercial Code) may be completed by the lender, which is then filed with the appropriate state agency with regard to the property that has an interest attached to it. This serves as notice to future creditors that the lender holds a lien on the listed assets. However, if your business is successful and can pay off the loan you should make sure that a release is filed in the same public office where the original UCC-1 was filed.

Last Word: Background Check for Buying Businesses

As this is the end of the year, I would like to recognize many people view the New Year as a time to begin new adventures, such as starting a business.  However, remember long ago rather than from starting from scratch you may consider buying an established business.  Why am I bringing this up?  Well, you just learned about security interests whether you are doing an asset purchase or an entity purchase it is wise to do some research.  Sometimes that research includes digging through UCC-1 filings to make sure the business or its assets that you want to buy don’t have outstanding loans or security interests on them.

This is the last Draw the Law post for 2012. Check back in the beginning of next year for new posts!

*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.

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.

 

Draw the Law” is a weekly short post where I try to visualize a legal concept.  It is designed to be helpful to small business owners and give them a quick overview of various aspects of the law that affect them.  For the next couple of posts I will detail how to finance a start-up.
In the prior post of this series we finished up with the variety of entity organizations, namely, sole proprietorship and partnership.

Now, that we have a business drawn up and have its “skeleton” outlined we will talk about the “blood” of the business or the financing of it.  What we need now is money!

Sources of Capital

There are a variety of methods of funding your business.  I like to divvy up those sources of money into three distinct categories.  They are as follows:

  1. Personal – what can you leverage on your own to raise money?
  2. Private – lenders and investors
  3. Government

Today, I will solely focus on personal methods of securing capital and then in Part II, I will discuss Private and Governmental sources.

Personal Sources

Let me list the personal methods first and I will turn to each one and briefly discuss them.  They are as follows:

  • savings
  • life insurance
  • retirement plans
  • home equity
  • stocks and bonds
  • credit card debt
  • loans from family friends

All of these represent the variety of personal sources that you could go to for money needed for starting your business.  I will now handle each one.

Savings

Savings is one of the easiest methods.  You just take what you have and spend it on the business.  All your cash in the bank use it on purchasing equipment, supplies, etc . . .  and it is as simple as that.  However, the reality is unless you are starting a business that has very little capital needs you are going to need to turn to other sources that draining your checking and savings accounts.

Borrowing Against Various Assets

In the case of life insurance, certain types of retirement plans, home equity, and stocks and bonds many people end up borrowing against these assets to raise the cash they need.  While, it is true you could cancel your life insurance policy, sell your home or condo, or sell your stocks and bonds most people would like to keep these assets for the long-term.  Instead they opt to borrow against the value of the item.  Typically, the loan that you are get will not be the full value of the item being borrow against, but some percent.

For the life insurance loan you would need to contact your insurance company.  For a home equity loan the bank that you owe your first mortgage on would be the first to turn to.  To use any stocks or bonds you own as collateral contact your broker.

Credit Cards

This method is as close to using your own savings to generate the buying power you need for equipment and the like for your business.  However, everything that goes on credit generally faces high interest rates if you cannot pay the balance of immediately.  In general, a credit card for the business is a good thing to purchase office equipment, make quick small payments, and emergency purchases, but should not be the primary method of financing the business as the interest rates will drain you over the long run.

Family and Friends

Here in Hawaii, we generally have a good family system where mom and dad, aunts and uncles, grandparents, and even calabash cousins will loan us some money to help our dreams come true.  While we like to trust in our family and friends, and hope for the best, it is also smart to just put the terms down in writing.  It should not be taken as an insult, but help avoid the creation of two different stories and future conflict should the business be unable to pay back the loan.  In addition, by having a promissory note, your relative or friend is in a better position to tell tax authorities that the money given to you was really a loan and not a gift, which have differing tax consequences.

Promissory Notes

These  are simple legally binding documents.  All they need to do is outline the terms of the loan, which includes the following parts:

  • identifies the parties;
  • how much money will be received;
  • what the interest rate is;
  • the amount of time you have to repay;
  • and the rate at which you will repay.

You can draft a promissory note yourself, so long as it has all the above components.  Just be sure to sign it, make a copy (to remind yourself of the repayment), and have the appropriate family member or friend hold onto the note.

If you are either party, the business owner or the family member or friend, and really concerned about such a loan you can always speak to attorney to make sure everything is in order. In addition to seeing a lawyer, for any method of financing you will probably want to meet with a financial adviser and accountant to make sure you have a firm grasp of how you will raise the money, expend it, and any debt obligations attached to it, as you get your business off the ground.

See you on the next draw!

*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.