Promissory Notes: The Insider Story

April 18, 2018 Shawn Murphy

Privately held companies on the IPO journey are often curious about promissory notes. As private companies, they can accept these loans as payment from employees to cover the cost of their equity award exercises. As public companies, will they still have the ability to extend these loans? It depends on who they are lending to.

Promissory notes to insiders

Under the Sarbanes-Oxley Act of 2002, publicly traded companies are prohibited from extending loans, including promissory notes, to officers and directors (i.e. insiders). Period. But under the Federal Reserve Act, Regulation T, a broker can extend a margin loan to an insider who is exercising options under an employee benefit plan that is registered on a Form S-8. What types of exercises are allowed? Even though the SEC hasn’t ruled specifically on this point, broker-assisted cashless exercises, such as same-day sales, sell-to-cover exercises and stock-swaps, have become common. So, in the case of an insider, an extension of credit by a broker is fine if the plan meets Regulation T requirements.

Promissory notes to non-insiders

While public companies can’t extend loans to insiders, there’s no issue with extending them to everyone else. Promissory notes to non-executives can avoid securities, tax, and accounting problems by providing for adequate interest and appropriate collateral. If the options are tax-qualified ISOs, the plan document, board resolution, and grant agreement must all specify that promissory notes are an acceptable non-cash consideration. With these notes or loans, the two key points are adequate interest and appropriate collateral, so let’s look at those more closely.

Adequate interest

Adequate interest means that the interest rate is set at the Applicable Federal Rate as defined by Internal Revenue Code Section 1274.  If the IRS deems the note holder company wasn’t charging enough interest, the option or stock will be treated as having been offered at a discount and will be subject to Internal Revenue Code Section 409A, which means the optionee will have to pay a 20% tax plus penalties at vesting. If the award was a tax-qualified incentive stock option, it will be disqualified and treated as a non-qualified option.

Appropriate collateral

And then for appropriate collateral, for tax purposes, having the underlying stock at risk qualifies as appropriate collateral. A most important point to remember is that if the stock is issued pursuant to Rule 144, the holding period doesn’t start until the shares are fully paid for.

As your company heads toward its IPO, you’ll want to make sure to work with your General Counsel to have compliant, written processes and procedures in place if your company chooses to offer promissory notes as a payment method for executives and others who are not corporate officers or directors.

Need help?

If you have any questions about how to conquer all the new regulations you’ll face as public company, get in touch! One of our IPO experts would be happy to help. And for news and market trends on IPOs, please join our IPO mailing list!

About the Author

As Director of Strategic Operations, Shawn Murphy ensures private companies receive the most comprehensive equity management solutions and software from Shareworks by Morgan Stanley. Formerly Executive Director at Morgan Stanley Australia, Shawn headed up Strategy and Business Development with a strong focus on talent management. Prior to that, she was co-founder of Morgan Stanley’s Microfinance Group in London, working to bridge the gap between capital markets and microfinance companies in developing countries. Shawn also has extensive experience in managing credit and operational risk across EMEA and Asia.

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