Hello, We are a private company. One of our employees has exercised his stock options by a promissory note. How should this transaction be journalized in our
Exercise Stock Option with Promissory Note
Answers
Anon,
It's an employee loan.
Make sure you charge interest and *don't forgive it*.
Repayment is just that; repayment of a loan.
Cheers,
KP
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
The accounting for the exercise of the option, the issuance of stock, and the Promissory note is pretty straight forward. However, for GAAP reporting, the Promissory note may end up being a contra equity account until paid. That is there has been no "paid-in" capital until the note is paid.
Personally, I'd discuss this with both my audit partner and tax partner there are a lot of land mines here that could surprise everyone if not done correctly.
Concurring with anon:
-this is a variation on letting an employee gamble with the company's money. If the gamble goes bad, bad things happen.
-Anon also mentioned the "forgiveness" issue. I strongly suggest looking into what happens when you forgive an employee loan. There are flavors of outcomes; the worst flavors are particularly bad (unreported deferred-comp penalties, etc). The IRS has taken action relative to past abuses, and you don't want to be caught in the dragnet.
Some of the variance depends on if they are execs or not.
Some light reading for you: http://www.jebachelder.com/articles/010321.html
In addition to interest collected, consider principal payments as well, at least nominal. You'll want to avoid an appearance it's not really a loan - you don't want to have an issue collecting the note when/if the employee leaves before there is a liquidity event. As you know, collecting monies from departing employees can be challenging in certain states. Make sure that your personnel documentation/communications consider the right of the company to offset the loan balance with unused vacation pay, bonuses, commissions etc. should the employee leave the company.
I just went through this issue with my company and will re-iterated some of the issues mention above:
1. It must be a recourse loan; otherwise, you lose any tax benefit of exercising those options. Please note that the
2. Don't infer or imply the loans may be forgiven. In our case the loans were paid but the employees were given a bonus later on.
3. In our case, our Accountant's advised us to keep the loans off the Balance Sheet.
4. Make sure you charge an interest rate that meets the IRS guidelines.
5. You can amend the notes to extend them, but only onetime; otherwise, it may not pass IRS scrutiny.
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