Can a Business Make a Note Payable to the Owner for Equity?
As a business owner, you can use profits generated by running your business to fund your business. Alternatively, you can use debt or equity as a funding source. Debt provides you with a claim on a company's assets in the event of default, and equity provides a claim on the company's earnings. A note payable is debt and therefore cannot be used to represent equity. However, you can use equity as the collateral for the note.
A note payable is the principal amount due on a written promise to pay a stated amount at some point in time. For notes with principal due within the ensuing 12 months, you record a note payable on your company's balance sheet as a short-term liability. For notes due in one or more years, record the note payable as a long-term liability. Debt is the amount of money you owe to another party or that person or company owes you. It creates an obligation to repay the money.
Equity is your ownership interest in the business. If your business is a partnership or LLC, your equity is called a partnership or membership interest respectively. If your business is a corporation, you are a shareholder and your ownership interests are shares in the corporation. With equity, you have a claim on the current and future earnings of your company. As an equity holder in the event your company fails, you must first pay all your debtors and other creditors. You will only have access to any residual assets.
You can lend money to your company and have your company issue a promissory note to you for the amount. Your note can be secured by specific assets your company owns or a blanket lien. However, most owner notes are unsecured. This allows you to obtain bank loans and loans from other lenders who require a more senior claim on your company’s assets. Alternatively, your note can be secured by equity in your company.
Say your company needs additional financing, but already has loans outstanding to two banks and an equipment lender. Therefore, your company has few assets to use as collateral. You decide to lend your company $50,000 at 6 percent interest for a term of three years. If your company cannot make the interest and principal payments to you during that time, it is in default. However, your promissory note is unsecured, so you would have little claim to any assets. You decide to use equity to secure the loan. In this scenario, if the company defaults on your loan, you get an additional equity stake worth $50,000 in the company.