What is a Promissory Note?

Remay Villaester (May)

Did you know that promissory notes were an early form of paper money? From Babylon to the British civil war, they have a long history. But the craziest thing about them is that they are still in use today. Maybe they could even be useful for your business? They are often easier than a loan or a bond and offer great flexibility.

In this article we’ll look at what a promissory note is, how they work, the different types of promissory notes, and examples of how they are used today.

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What is a promissory note?

A promissory note is an unconditional written promise by a person (including companies) to pay someone else a specified amount of money at a future date. It is usually made in return for a loan or credit. It is a legal document and enforceable under UK law

It is more formal than an IOU but less complicated than a big loan document.

The grandfather of paper money

Promissory notes have a very colourful history. The earliest form was mentioned in a Babylonian legal text, Hammurabi’s Code. A form of promissory note was also used by the Chinese called “flying cash”. But they are usually associated with trade in renaissance Europe. It helped merchants to buy and sell goods in other countries - it was the Wiseof its day.

It was also the grandfather of paper money because the original recipient could give it to other people as a form of payment. In the 17th century, London merchants began to keep their gold, silver, and coins with London’s goldsmiths for safekeeping after Charles I had seized their holdings from the Tower of London.

The goldsmiths began to provide the merchants with promissory notes based on their deposits so the merchants could make and receive payments without having to physically move their wealth. The goldsmiths also saw an opportunity to loan out gold and silver using promissory notes.

How does a promissory note work?

All the details of a promissory note are written down on a physical piece of paper and signed by the parties involved. Electronic promissory notes are not valid under English law but this may change in the future.² A promissory note can contain all the terms of the loan or can refer to a more detailed loan document. The holder of the note must present the note to the maker to receive payment.

Like money, a promissory note is a negotiable instrument and can be transferred to other people. A payee can transfer their note to someone else by signing it to them (indorsing). A bearer type note can simply be handed to someone else.

If a payment is missed or the borrower defaults on the note, the holder of the note can send a demand letter to the borrower. If the borrower cannot make payment, the holder can start to seize any collateral that was stated on the note.

Their basic operation is set out in the Bills of Exchange Act 1882. Commercial agreement promissory notes, personal notes greater than £30, and notes for business purposes of amounts greater than £25,000 are also governed by the Consumer Credit Act 1974 and 2006.

What are the types of promissory notes?

Promissory notes are can be categorised in the following ways:

  • Those with terms (final payment dates) vs. Payable on-demand
  • Payable to specific persons vs. Payable to a bearer
  • Single payment vs. Installments
  • How any interest is calculated
  • Whether they are secured by collateral or not
  • By the reason for lending the money e.g. student loans, business loans, car loans, etc.
  • Whether it is governed by the Consumer Credit Act or not

What is included in a promissory note?

A promissory note typically includes the following details:

  • The payment amount also called the principal
  • The name(s) of the payer(s) also called the maker(s) or borrower(s)
  • The person to be paid at the future date (the payee or lender) OR the note can be made out to the “bearer” i.e. whoever has possession of the note
  • The addresses of the parties
  • Signatures of the parties
  • The final payment date or term of the note. Alternatively, the note can be marked as payable on-demand
  • A specific place for the final payment can be specified
  • How payments are to be made including if payment is to be in part or in full, whether interest is to be paid and how it is calculated, and details on any late fees
  • Whether any collateral is provided and details of the collateral
  • Details of any insurance
  • The governing jurisdiction

Example of how promissory notes are used today

Businesses use promissory notes to get short-term credit and to secure loans and payments, this includes:

  • Short-term corporate credit promissory notes: Businesses use this to get much needed short term funding when other options like bonds or loans have already been tried. It can help provide a quick liquidity fix while waiting for key receivables to be paid. Companies can even provide the note to creditors rather than cash.

  • Convertible promissory notes: This provides potential investors with the flexibility of being repaid with interest or converting their note to shares in the issuing business. It gives them more time to look into a business before taking equity and allows them to easily exit the investment if they change their mind. Such flexibility can help businesses attract investors who otherwise would be reluctant to invest straight up. It is also popular with Venture Capitalists when investing in startups.

  • Trade promissory notes: Promissory notes can smooth out the liquidity delays in importing and exporting. Importers can use a promissory note to secure supply of exports while deferring payment to later. The exporter then has the option to transfer the note to another party for cash if it needs liquidity sooner.

In fact businesses can use promissory notes to secure any type of credit, loan or accounts receivable. Rather than take someone’s word for a critical payment or issue an invoice and hope for the best, you could use a promissory note.

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          Sources used:
          1. gov.uk - legislation
          2. gtreview article

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