When it comes to employee compensation, companies constantly explore innovative ways to align their workforce's interests with the organization's success. One strategy gaining traction is the extension of loans to employees to facilitate the exercise of stock options. While this approach has apparent benefits, a cautious stance is crucial due to the intricate complexities and associated risks.
This issue gained attention in 2022 when Ryan Breslow, founder of Bolt Financial, proposed extending loans to employees to exercise their options. Concerns about the risks associated with this concept were underscored when Bolt issued layoff notices to one-third of its employees, reportedly including some who had accepted the options-financing offer.
On the surface, offering loans for stock purchases may seem generous, but it comes with various risks. The inherent volatility of stock prices introduces unpredictability. In the event of a decline, employees may be obligated to repay loans with personal assets. The legal and regulatory landscape surrounding employee loans for stock purchases is intricate, with tax implications and securities laws complicating the process. Failure to navigate these rules appropriately can result in legal repercussions and damage the company's reputation.
As startups choose to remain private for extended periods, the challenge of financing options purchases has become more prevalent. The question of what happens if the company never achieves a successful exit, or even if it does, its valuation could be lower than the employees' option strike price, adds complexity to the situation. This scenario is increasingly evident among workers in recent public companies whose stock prices have experienced significant declines, sometimes falling below their initial public offering (IPO) prices.
In summary, while extending loans to employees to exercise stock options can sound like a perfect solution, it may also inadvertently create adverse incentives where the employee owes the company money but is left holding underwater or worthless equity. While this niche approach has upside in specific situations, we typically recommend alternative approaches (described below), especially when more than a few employees are involved.
Loan Essentials: Navigating the Regulatory Landscape
To mitigate risks and ensure compliance, companies that adopt this approach must issue written promissory notes that clearly outline the terms and obligations of the loan agreement, including:
- The company's expectation of repayment and the employee's intent to repay.
- A fixed maturity date – the date the borrower must repay the loan – is also referred to as the "term."
- An interest rate at least equal to the applicable federal rate (AFR) applicable to the loan term at issuance.
- A requirement to make interest payments in cash at least annually.
- A requirement to pledge the shares purchased with the loan proceeds as collateral.
- An acknowledgment and agreement that the loan be at least 51% personal recourse to the borrower. This is a critical component to make these types of arrangements work from a tax and compliance perspective, but it also makes these arrangements risky for employees.
In addition, most promissory notes specify that the loan must come due upon the occurrence of intervening events like termination, change in control, and filing of a registration state for an IPO (due to the Sarbanes-Oxley Act, which prohibits loans between public companies and their directors and officers).
Because of these requirements, employees can be left owing more on the loan than the pledged equity is worth if the stock price falls, putting employees in precarious personal financial positions. Considering worst-case scenarios is imperative, as well as contemplating potential outcomes if the stock price experiences a decline. Companies should evaluate alternative methods for employees to repay loans and assess risks associated with loan forgiveness, which generates taxable income for employees and introduces accounting complexities for the company.
Alternative Strategies: Mitigating Risks and Fostering Equitability
Considering the risks associated with employee loans, companies may consider alternative strategies:
- Net Exercise: Perhaps the easiest alternative is to allow employees to pay for the cost of exercising options using the inherent value of the options at the time of exercise (often called the "spread"). Net exercising permits the option holder to surrender a portion of in-the-money options back to the company to cover the exercise price. The downside is that the employee ends up with less equity, which will impact the incentive stock option status of the options that are surrendered. The upside is that no employee cash outlay or loan is required. The company can also permit net exercise to cover employee withholding tax obligations (although this requires the company to pay all taxes with its own cash and is, therefore, rarely used).
- Extended Exercise Periods: Instead of loans, consider extending exercise periods, which provide employees a longer timeframe to accumulate funds for stock option exercises. However, extending exercise periods for existing awards can have adverse tax consequences, particularly for employees with incentive stock options. It should never extend beyond the original expiration date of the option (which is generally ten years after the grant date).
- Stock or Phantom Equity Grants Instead of Loans: Offering stock grants (additional options) or phantom equity (restricted stock units or stock appreciation rights) can serve as a compelling incentive without introducing the complexities associated with loans.
Prioritizing these alternative solutions mitigates the risks associated with employee loans and demonstrates a commitment to fostering a financially sound and equitable workplace. Before implementing any strategy, engaging with professionals to tailor these alternatives to your organization's unique needs and regulations is crucial. By doing so, companies can unlock the potential benefits of stock options while minimizing the associated risks.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
