Promissory Note When Starting a Business With a Partner

Two co-founders agree on a 50/50 split. One has $80,000 saved. The other has $10,000 and a great idea. They start the business. Five years later they sell for $2 million and split it down the middle. The first partner is furious because their $70,000 head start was never repaid. The fix is one document at the start: a promissory note from the company (or the other partner) for the cash gap, repaid before profit splits.

The unequal-contribution problem

Three ways to handle unequal cash contributions:

1. Adjust equity: the bigger contributor gets a larger ownership stake.
2. Capital account credit: the bigger contributor has a higher capital account balance, paid out first at dissolution.
3. Promissory note: the company (or the other partner) signs a note for the difference.

Notes are often the cleanest because they create a defined repayment with interest, separate from operations.

Note from the company vs note between partners

From the company. The cash went into the business. The business owes it back. Both partners share in the company\'s ability to repay (since they own it together).

Between partners. One partner paid the other directly (often for the smaller partner\'s buy-in). The receiving partner owes it back personally.

Most start-up scenarios use the company-note structure. The contributing partner becomes a creditor of the company.

How the structure works

1. Both partners agree on equal equity (50/50).
2. Partner A puts in $80,000. Partner B puts in $10,000.
3. The company signs a note to Partner A for $70,000 (the imbalance) at, say, 6 percent over 5 years.
4. Both contributions are credited to the partners\' capital accounts equally ($10,000 each).
5. The company repays the $70,000 note from operations. Once paid, both partners have equal capital and equal equity.

Why this beats equity adjustment

• The contributing partner gets cash back, not just a paper-larger slice
• The repayment timeline is fixed (no waiting for sale or dissolution)
• Equity stays clean and equal (matches the partners\' day-to-day work)
• If the partners later raise outside money, equal equity is easier to explain
• Interest is tax-deductible to the company

The note terms

• Principal: the cash imbalance
• Interest rate: AFR or modest market rate
• Term: 3-7 years typical
• Payment schedule: monthly amortization, or quarterly, depending on cash flow
• Subordination: junior to outside investors and bank debt (if any)
• Default: company insolvency, missed payments, dissolution
• Prepayment: always allowed

Subordination

If the business later borrows from a bank or raises outside investment, those lenders/investors will require the founder note to be subordinated. That means:

• Bank/investor gets paid first in any default
• The founder note may not be paid down while the senior debt is outstanding (or only with consent)
• The founder note may have to be converted to equity in certain events

Build subordination flexibility into the note from the start so you do not have to renegotiate later.

Operating agreement integration

The LLC operating agreement (or shareholder agreement for corporations) should:

• Reference the note as an existing obligation
• Treat note payments as senior to member distributions
• Explain how the note interacts with capital calls (does the contributing partner have to call too?)
• Clarify what happens to the note if a partner exits
• Address how the note is treated in a sale of the company (paid off at closing, typically)

Tax treatment

• For the company: interest paid is deductible
• For the receiving partner: interest received is ordinary income; principal payments are recovery of capital (not income)
• If the rate is below AFR: imputed interest applies; speak with a CPA
• For the partnership tax return: the note must be reflected on the balance sheet as a liability and the partner\'s capital account treated correctly

Common drafting mistakes

• Note silent on subordination (creates issues at first investor round)
• Note silent on what happens if a partner exits (does the note accelerate?)
• Note rate below AFR (IRS imputation issues)
• Note repayment ahead of company\'s ability (creates default the partners did not want)
• No interaction with operating agreement (capital accounts get tangled)

What to do if cash flow can\'t support the schedule

Build flexibility in:

• "Interest-only for first 18 months" gives the business runway
• Acceleration on liquidity events (M&A, refinancing, certain milestones) instead of strict monthly
• "Pay when able" with a hard maturity date (less rigorous, but ok between founders who trust each other)

If the business sells before the note is paid off

The note typically pays off at closing. The contributing partner gets their remaining principal plus accrued interest from sale proceeds before the equity proceeds are split. Standard structure:

1. Pay off senior debt (bank, investors)
2. Pay off founder notes
3. Distribute remaining proceeds per equity ownership

Alternative: convertible note

Some founder loans are structured to convert into additional equity at a future event (e.g., next funding round). This is more common when the contributing founder might want upside if the business succeeds rather than just principal back. Discuss with counsel - convertible notes have securities-law and tax implications.