Should a company allow option exercises with promissory notes?

January 18, 2009

I typically discourage companies from allowing option exercises by means of a promissory note. Promissory notes can provide employees a means of exercising options and starting their capital gains holding periods without coming up with cash. However, the promissory notes must be substantially full recourse to start the capital gains holding period, which creates a real obligation for the employee even if the stock eventually becomes worthless. A bankruptcy trustee might attempt to collect on a full recourse note in the event the company goes bankrupt. Full recourse means that the note is a general obligation of the employee, as opposed to recourse being limited to the stock purchased in the event of default.

If the promissory note isn’t substantially full recourse, then the option isn’t deemed to be exercised for tax purposes. If the note is repaid (or forgiven) in the future and there is a difference between the purchase price and fair market value at that time, then the employee may have a taxable event. In addition, if the note is forgiven, it will create debt forgiveness income to the employee.

Promissory notes can create accounting problems for the company as well, and they create administrative complexities. Finally, loans to executive officers have received intense public scrutiny over the past several years, and public companies are now barred from making loans to (or materially modifying existing loans to) executive officers.

Comments

  • http://www.altgate.com/ fnazeeri

    As a general rule I agree. But there are valid exceptions to this, which I think you too would agree with. For example, bringing in a CEO who replaces the founder and has the net worth to handle a full recourse loan but current cash flow doesn't allow an outright stock purchase.

  • http://www.startupcompanylawyer.com Yokum

    Yes, if a company/exec came to me with this fact pattern, I'd get comfortable with it.

  • http://www.startupcompanylawyer.com Yokum

    @fnazeeri – Yes, if a company/exec came to me with this fact pattern, I'd get comfortable with it.