At some point in the life of your business, you will likely need to borrow money -- particularly if you need to buy new equipment or inventory. Loans from banks or other institutional lenders are always made using a number of documents, two of which are a promissory and security agreement. In general, the promissory note is your written promise to repay the loan and a security agreement is used when collateral is given for the loan.
Promissory notes used for business loans come in two basic types, unsecured and secured. An unsecured promissory note means that the lender did not require collateral for the loan. If you default, the lender's only recourse is to file a lawsuit to enforce the terms of the note. A secured promissory note is used when the lender requires collateral for the loan, such as a pledge of business equipment, inventory or accounts receivable. When a default occurs on a secured note, the lender has the option of using the collateral to satisfy the note, often without the need to file a lawsuit.
Advertisement Article continues below this adA security agreement is used in conjunction with a secured promissory note. The terms of the secured promissory note typically includes a reference to the security agreement and a brief description of the related collateral. The security agreement will specify in greater detail the business property given as collateral. If the borrower defaults on repaying the note, the agreement will specify what action the lender can take to seize the collateral, such as demand a turnover of possession of the collateral.
Although not legally required for a valid promissory note and security agreement, lenders typically take an additional step when business property is given as collateral for a loan. This step is called "perfecting a security interest" and is accomplished by filing a National Financing Statement with the secretary of state where the collateral is located. This is a standardized form used in all states and is commonly referred by the designation "UCC-1." Filing this document is similar in effect on the collateral as recording a mortgage or deed of trust against real estate -- it provides notice to the public that the property has been pledged as collateral and to whom.
Advertisement Article continues below this adUsing 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. New lenders may be unwilling to lend funds with another lender having a prior security interest in your business property. A better approach, if possible, is to make a credit agreement with your lender rather than a one-time loan. Such an agreement also includes the use of a promissory note and security agreement, but has the added advantage of obligating your lender to make future advances so long as you meet certain repayment conditions.