Are Promissory Notes a Good Investment?
By Charles Schaffer
A promissory note is a legal document that contains a written promise for a borrower to pay a certain amount of money to a specific person or entity — the lender. A promissory note is a binding contract between a borrower and an investor ("lender" and "investor" are synonymous terms).
Lenders may use promissory notes to debt-finance land and property development projects.
Many accredited investors include promissory notes in their portfolios — as the right type of note can provide above-average annual returns with a lower risk of capital depreciation than other types of investments.
Promissory notes have been scrutinized by governing bodies such as FINRA, partly because of several high-profile fraud cases.
The lessons learned from fraud cases are that an investor should assess several things about a borrower first. These assessment points are covered below.
Secured vs. unsecured notes
A secured promissory note is a payment obligation secured by a property of some kind. If the borrower fails to pay, the lender can seize the designated property to obtain reimbursement after a foreclosure process.
In some cases, a promissory note will also contain collateral, which is something of value that the borrower agrees to put up as security in case they default on the loan.
An unsecured promissory note is a pledge by the borrower to pay back the lender without any property securing the payment. The borrower may provide a personal guarantee as part of the note.
If the payor fails to pay, the payee must negotiate a resolution or legal action and hope that the payor has sufficient assets to satisfy the loan.
With an unsecured note, you should learn more about who you are investing with and what you are investing in.
The promissory note is due on the date specified in the note. If a date is not specified, the note is due on demand.
Characteristics of a promissory note
A promissory note has no capital appreciation per se, as notes are not bought and sold on the open market.
Here are several things to know about promissory note investing.
The annual interest rate
Higher-than-average interest rates are the appeal of promissory notes. The annual interest rate can be 10%, 20%, or higher.
If you were to invest $50,000 in a three-year promissory note with a paid-out interest rate of 20% annually, your total return on investment would be $30,000 in current dollars plus the return of your original principal.
A note may give the lender an option to compound the interest instead of receiving an annual distribution.
Interest payment frequency
The frequency of interest payments for a promissory note is monthly or annually, depending on how the borrower uses the funds.
Term of the note
The term of the promissory note is the length of time an investor locks up their principal. The term can range from months to years. At the end of the term, the lender gets their principal back.
Minimum investment
A note may have an associated minimum investment, such as $50,000, and may be dependent on how and what the borrower is using the funds for in their business. A lender can choose to invest an amount greater than the specified minimum. Promissory notes usually have a higher minimum investment compared to equity investments.
Total amount raised
It's important to look at the minimum investment compared to the total amount raised.
The investor pool may be too limited if the minimum investment is $50,000 and the total raise is $200,000. On the other hand, if a borrower raises tens of millions of dollars and sells notes too broadly, the investor pool may be too large.
A personal guarantee
While borrowers are often companies, an unsecured note may include a personal guarantee from the company's principal or principals. In the document, these individuals are referred to as 'guarantors.'
Investor due diligence
As part of your risk assessment for promissory note investing, you should vet the lender. Here are some questions to ask.
To what business or entity are you lending money?
Did they come to you — or did you find them?
What is the borrower's track record?
Has the borrower provided a full set of information?
In what sector is the investment?
Is the note for a large fund or is it earmarked for a defined set of projects?
Regarding the sector — as you know, the economy moves through cycles. These cycles determine which sectors are in expansion mode and which are in contraction mode. In 2022, the technology sector has underperformed. However, the renewable energy sector has over-performed.
Also, seek a borrower who lays out the facts and lets you make a decision rather than trying to sell you something.
So, yes — promissory notes can be an excellent investment. But it's important that investors do their research first.
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Charles Schaffer
President and Founder, SDC Capital Ventures
Charles has founded and operated several development companies over his 35+ year history to pursue his passion for Alternative Investing where he believes outsized returns can be achieved without a corresponding increase in risk. Under Charles' leadership, SDC has developed and financed over $80 million of commercial real estate and renewable energy projects.
