Should a company allow option exercises with promissory notes?

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.