If you’ve been in the construction industry for any length of time, you know it can take a long time to get paid. While a mechanics lien is the most effective payment tool available to construction businesses, it’s not the only one. In fact, because contractors and suppliers carry so much financial risk, they are best served by protecting their payments using several tools simultaneously. A promissory note is less common in construction, but when used effectively it can be a helpful addition to a collection toolbox.
What is a promissory note?
A promissory note is a written acknowledgement of debt, and a promise by one party to pay a specific sum of money to another party. It is a legal document that rests somewhere between an IOU and a loan contract. An IOU acknowledges that a debt is owed, and a loan contract delineates all the terms of the loan agreement, including how payment will be made.
Promissory notes are usually issued between two parties that aren’t banks, like a contractor and supplier. Banks use them for mortgages and other loans, but construction businesses can use them effectively as an added layer of payment security.
Types of promissory notes in construction
While all promissory notes are inherently similar, they are several particular types of notes used in construction.
Contractor promissory note
A contractor promissory note can be used in two ways. A contractor may issue one to a supplier or subcontractor; or they may issue a promissory note to their client, like a general contractor or project owner. In both cases the payment agreement between the two parties is laid out in the promissory note.
Contractor promissory notes are best used when the amount owed is a known quantity. Some suppliers ask contractors to sign a promissory note to cover all their purchases as a way to get a written acknowledgement of a specific debt.
Construction loan note
Construction loan notes are used most frequently by cities and other jurisdictions on public construction projects. They are issued by the jurisdiction to the contractor performing the work to help guarantee payment from the jurisdiction’s funds. Then the jurisdiction will issue municipal bonds to help replace the funds spent on the project.
A construction loan note is nothing more than a promissory note between a municipal body and a contractor regarding a project.
Building materials note
Similar to a contractor promissory note, a building materials note is sometimes issued between a contractor and a supplier. The note helps guarantee that payment will be received by the supplier for the building materials purchased.
A building materials note may also be issued by someone who agrees to pay the debt for a contractor — for example, in the event that the obligor is deceased.
How construction pros use promissory notes
In a LinkedIn poll, 53% of credit professionals said that promissory notes are useful for arrangements on past due accounts. Because a promissory note is a legal acknowledgement of the debt, it can provide extra payment protection — particularly in the event that the business is in financial trouble.
“A promissory note is certainly a good security instrument,” says Jay Halprin, a Senior Vice President with Rauch-Milliken International, Inc. “A creditor would rather have this added layer of protection than not, as it prevents a business owner from closing his or her doors and simply walking away from the payment obligation scot-free.”
“From a creditors standpoint, it really helps against those companies who like to play the shell game,” says Brandon James, Chief Business Development Officer at Tucker, Albin and Associates. “When you have the ability to hold them obligated to the debt personally, then it mitigates any chances of them using the company being out of business as an excuse not to pay if they are still operating under a different name.”
The limits of a promissory note
However, while a promissory note can be a useful security measure, it should never be used as a replacement for a company’s lien rights.
“Converting an open account obligation to a promissory note should be done cautiously, so as not to unknowingly surrender any rights, such as lien rights that may exist under the open account,” says Rich Adams, CEO of Southwest Business Credit Services.
While a majority of construction credit professionals believe that promissory notes can be a useful payment tool, there is a limit to their effectiveness.
“Like any debt, there has to be some sort of financial backing in order for it to really be effective,” says Brandon James. “If they don’t have any money, then it’s no better than a default judgment in my opinion.”
“At its core, the promissory note is only as good as the credit quality of the individual signing,” says Brad Loehner with Priority Credit Management Group. “We recommend a thorough examination of the person’s credit before the proposed transaction takes place. If the note is taken as added security after the transaction, it can be too little too late.”
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Promissory notes vs. other payment tools
A construction contract is an agreement between two parties about work to be performed and the amount of money paid for that work. It includes terms stating what recourse each party has if the other one doesn’t comply. Contracts are legally binding and hold up in court.
While a promissory note is effectively a contract on its own, it can also act as an addendum to an existing construction contract, modifying the payment terms or dates in the original agreement.
Contractors and material suppliers use credit applications to gather information to help them judge the credit worthiness of the purchaser. The information provided on the application helps them determine if the customer is a good financial risk or not.
Unless specific terms are included on the credit application, the application itself is not an agreement to pay. Some suppliers may attach specific payment terms, similar to a promissory note, to their credit application.
A purchase order is a simple contract authorizing an exchange of work or materials for a stipulated amount. Depending on the terms attached to the purchase order, it may be similar to a promissory note. Adding terms regarding payment dates and interest, if applicable, will strengthen the contract and make it similar to a promissory note.
A personal guarantee ties the debt to the business owner or an officer in the company and allows the vendor to collect from or sue them personally to recover the money owed. A personal guarantee may have similar terms to a promissory note.
A promissory note is a payment agreement between two parties — if the paying party doesn’t follow through, the unpaid party doesn’t have the right to seek payment from someone else. In contrast, a mechanics lien attaches the unpaid debt to the property itself. It doesn’t matter if your customer was the property owner or a subcontractor on the job — a mechanics lien allows you to leapfrog your direct customer and go straight to the source of funds on the project.
A mechanics lien gets multiple parties involved — the owner, the lender, the general contractor, and possibly others. A promissory note is an agreement that money is owed, but it doesn’t spell out how to collect if the customer can’t pay. Even if you have a promissory note with a customer, a mechanics lien will always be a more effective pathway to ensure collection.
How to write a promissory note
Each state has its own laws about what has to be included in a promissory note, but they have similar elements. A promissory note should include the following information:
- Name(s) of the borrower(s)
- Name of lender
- Amount of debt
- Interest rate
- Payment schedule
- Repayment deadline
- Venue for dispute resolution
- Collection of attorney fees & court costs
Interest may be charged as simple interest, compounded interest, or any other way to calculate interest, depending on state regulations. The payment schedule may be monthly, weekly, or any other schedule that works for both parties.
Specifying the collection fees and venue for dispute resolution in the promissory note is important. “These should absolutely be included,” says Lori J. Drake, CBA, a longtime credit professional and current manager of Levelset’s Payment Professionals Community. “If they aren’t you could wind up trying the case three states over, losing attorney and collection fees and more.”
If property is being held as security or collateral, it should be noted in the promissory note. Both parties must agree to the note’s terms and sign the note to signify their agreement.
Examples of promissory note terms
Below are some sample clauses that are common in construction promissory notes, specifying the terms related to interest, venue selection, and collection fees the note holder is entitled to. Before issuing a promissory note (or any contract for that matter), consult with a construction lawyer to ensure that the note terms are legal and enforceable in your state.
Should default be made in any payment provided or not provided in this note, the holder will send notice to signer outlining the default, and note their intention to accelerate the outstanding balance and interest accrued. This notice will also allow the holder to incur an increased rate of interest at the increased rate of five percent (5%) per annum over and above the rate contracted herein. No delay or omission on the part of the holder hereof in exercising any right hereunder shall operate as a waive by signer of such right or any other right under this note.
This agreement and the rights of the parties hereunder shall be governed by and construed in accordance with the laws of the State of ______ (wherever the note holder resides) for all matters. Any action brought by the holder shall be brought in the State of ____ (wherever the holder resides) in the Count of _______ (whatever county the holder resides in).
Attorney & collection fees
In the event of any dispute, relating or referring to this agreement, including but not limited to collection actions, breach of contract/agreement actions, declaratory judgment actions or equitable injunction actions, the holder will be entitled to all collection costs, reasonable legal costs, expert fees and attorney fees.
The holder agrees it will not file for a confession of judgment unless and until an event of default or a trigger event (as defined in the notes) under the note has occurred; provided, however, that upon such an event of default or trigger event, the buyer shall be entitled to immediately file such a confession in an ex parte fashion. At such time, the judge may issue a judgment in favor of the holder of the agreement against the signer for the amount that may be due, as noted above, and to waive and release all errors in said proceedings and judgment, and all petitions in error and right of appeal from the judgment rendered.
Don’t rely on promissory notes alone
A promissory note is one tool in a contractor’s payment toolbox. When properly used, promissory notes hold up in court and can be enforced through a lawsuit, if necessary. While construction businesses have other more powerful forms of collection — like a mechanics lien — a promissory note can be an effective negotiation tool. However, it should never be used as a replacement for filing a lien claim, or used to give up lien rights.The good news for contractors is that they rarely need to file a lien claim as long as they follow the steps in the mechanics lien process. Sending notices — whether they are required or not — is often effective on its own to ensuring that your customer pays you on time.