Consider this fairly typical situation. Four years ago, employee Emma was granted an incentive stock option (ISO) to purchase 100,000 shares with an exercise price of $0.86 per share. Emma’s award is fully-vested and she wants to exercise her option now because she knows that she has to hold her shares for at least a year after exercise in order to get beneficial tax treatment. The problem is, Emma doesn’t have $86,000. And, even if she did (and as committed to the company’s vision and prospects as she is), $86,000 is a big sum for an employee of her means to put at risk in an emerging company. And, it turns out, Emma is critical to the company’s future success.
Or what about this one? Last week, key new hire James successfully convinced his new employer to grant him an early exercisable stock option. The option gives him the right to purchase 62,000 shares with an exercise price of $4.03 per share. James wants to take advantage of kick starting his capital gains holding period by buying the shares now and making an election under Section 83(b) of the federal tax code. But James doesn’t have $249,860 to spare.
When faced with situations like these, it doesn’t take long for a company to propose (or for an employee to ask for) a loan from the company to pay for the option’s aggregate exercise price (and potentially applicable withholding taxes too). After all, even if the company itself is cash-strapped, it doesn’t actually have to come out of pocket for the amount of the loan to pay an exercise price (because the employee would only turn around and pay it right back to the company to exercise the option) and, the thinking goes, the loan itself can be paid off at the time of a liquidity event. Easy-peasy, right?
In this fourth and final part of our four-part series on commonly-considered option program enhancements we do a deeper dive into making loans to employees to purchase company stock. As with the other practices and programs we have looked at, including the use of extended post-termination exercise periods, while employee loans are technically possible and not infrequently used, companies should proceed very carefully, consider the pros and cons, and seek advice of tax counsel before implementing them.
Essential Loan Provisions
As a threshold matter, it helps to understand that while compensation income is generally taxed to an employee as and when it is paid, an employee loan—provided it is a bona fide loan—is generally not considered income to the employee and therefore is not subject to tax. Because of this, the tax authorities are inherently skeptical of loans between companies and employees.
To ensure that a loan is not recharacterized as disguised compensation, it is critical that any loan between a company and its employee evidence both the company’s expectation of repayment and the employee’s intent to repay. The loan should therefore be documented by a written promissory note and the provisions of the loan should, at a minimum, include:
- A fixed maturity date (that is, a fixed period of time at the end of which the borrower will repay the loan).
- An interest rate that is no less than the applicable federal rate (AFR) appropriate for the applicable term of the loan at the time the note is issued, with interest payable in cash at least annually.
- A requirement that the shares purchased with the proceeds of the loan be pledged as collateral to secure the loan.
- An acknowledgment and agreement that at least 51% of the principal amount of the loan is personally recourse to the borrower. This is because the employee must acquire “beneficial ownership” of the shares in order to be treated as a stockholder (and start a capital gain holding period) for tax purposes. And where indebtedness is used to purchase shares but there is no personal liability to pay all, or a substantial part, of the indebtedness used to purchase the shares – that is, if the borrower hasn’t personally assumed the risk that the value of the stock will decrease – the borrower will be deemed not to have acquired beneficial ownership of the shares. Accordingly, any loan between a company and employee for the purchase of company stock, even secured (as described above) by the shares being purchased, should be at least 51% personally recourse.
- A requirement that the loan come due on certain events that occur before the fixed maturity date. Thought should be given to other events that will trigger repayment of the loan. For example, employee loans commonly come due upon any termination of employment and upon a change in control. It is also critically important to include a requirement that the loan must be repaid before the company becomes subject to Section 402 of the Sarbanes-Oxley Act by becoming a public company, since the law makes loans between public companies and their directors and executive officers illegal. And, because this law applies upon the initial public filing of a company’s registration statement for an initial public offering (IPO) (which occurs before the company actually becomes publicly held), the employee cannot use the proceeds from his or her sale of shares in an initial public offering to repay the loan. Though such a repayment requirement should certainly be included in the loan, be forewarned that if the loan is not settled before the IPO process begins, it can result in some distracting (or even painful) discussions with management regarding the timing and disclosure of the settlement of any outstanding loans.
Hope for the Best but Plan for the Worst
Before agreeing to enter into a loan with an employee it is important to that both parties understand the terms to which they are agreeing. While it is possible that the shares which are acquired using the loan and which are pledged as collateral for the loan will at all times be worth more than the amount of the indebtedness, that is certainly not always the case: companies falter, markets slump, pandemics happen. As much as we would want them to, stock values do not always go up and to the right. And if the value of the shares purchased with the loan proceeds is not sufficient to settle a loan when it comes due, an alternative means of repayment will have to be found. If the employee cannot fund the repayment through their own cash or a new loan from a third party, forgiveness of the loan may be one of the few viable alternatives remaining. But even that is not without its costs. Loan forgiveness creates taxable compensation income for the employee, including a company withholding obligation (with no cash to pay the tax), and has adverse accounting consequences. These risks to the company are real and often are the reason that boards determine that employee loans to purchase shares are not advisable.
When it comes to stock option programs, simplicity is often the name of the game. After all, in order for a stock option to act as an incentive it must be capable of being understood by the recipient of the award. However, increasingly, employees are asking for – or companies are offering – options with as many bells and whistles as possible, in an attempt to get the recruiting edge. But as we covered in this four-part series, each of the most commonly considered enhancements has its own benefits, pitfalls and complexities. It is certainly the case that one size does not fit all when it comes to equity compensation incentives. Seek counsel from those who know your geography, your industry, your company and the law so that any enhancements on the stock option programs you ultimately decide to offer are thoughtfully established and put your company in the best position possible to recruit and retain talent.