By David SniderFinances — April 21, 2020

Promissory Note Program: A Financial Employee Benefit for Early-Stage Startups

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I had previously been a Chief Operating Officer and a Chief Financial Officer at a large tech company, and I wanted to do things a little differently than most other startups when it came to helping our employees reach their own optimal financial outcomes.

When most startups hire their early employees, they use equity as an incentive to bring talented people on board. However, this equity is typically offered in the form of stock options, and while this can seem appealing, it often creates real financial and logistical problems for employees down the road.

I don’t want my team faced with the challenges associated with a traditional stock option program. We created an employee-friendly program that allows them to own stock in the business outright without having to shell out significant cash to exercise options or pay taxes upfront on equity that has yet to earn them any real money.

To do this we created a promissory note program. This program is unique within not just fintech and startups, but as far as we know, any other major industry as well.

The Hidden Downsides of a Traditional Equity Program

With most startups, employees are offered equity options as part of their compensation package. The problem with that is, these equity options generally require a large out-of-pocket investment on the part of employees to convert from options to stock.

If someone leaves the company for any reason the employee will typically lose their vested equity unless they exercise their options within a limited period of time — usually 90 days. Exercising options requires employees to pay the option exercise price and, in some cases, to pay income tax too — and employees usually can’t sell their shares to come up with the cash.

This is why you hear of employees from some startups forced to borrow to keep their shares or more often having to forfeit the right to that equity, which can become quite valuable. It comes down to a timing issue, as there is an upfront cash cost for a speculative payoff down the road. According to a 2019 Charles Schwab survey, 76% of startup employees never exercise or sell the pre-IPO stock options they have earned.

For many employers this “unintended consequence” ultimately places golden handcuffs on employees, especially as the business grows in value and gets to recoup issued and vested equity from employees who choose to leave and pursue other jobs without the cash to exercise. This industry-standard approach to stock options ultimately favors employees who have, or are able to come up with, substantial amounts of cash.

And even when employees do remain with the company until a liquidity event — which happens if the company is acquired, merges with another, or goes public — founders are treated much more favorably by the IRS.

That’s because founders usually have their equity not in options, but in stock, which is taxed under lower long-term capital gains rates. And in some cases, the Qualified Small Business Stock (QSBS) tax exemption even allows founders to avoid this capital gains tax and receive millions in value from their equity without paying taxes. Typical employees with stock options, on the other hand, are taxed at their ordinary income tax rate when they go to sell their equity options.

The Harness Wealth Promissory Note Program

We devised a unique promissory note program that allows for the cash-free exercise of options, providing:

  1. Optimal tax rates
  2. Allowing access to equity for employees who do not yet have the personal wealth to exercise
  3. Preventing the “golden handcuff” scenario so that employees do not feel restricted from leaving the company if they wish to do so

The promissory note carries the lowest interest rate allowed by the IRS and the interest is accrued (not owed in cash). The exercise cost is owed after 7 years. 50% of the note is backed only by the stock and 50% is recourse.

ExamplesTraditional Stock Option ProgramHarness Wealth Promissory Note Program
Number of Options10,00010,000
Exercise Price$1.00$1.00
Date Options Can Be Exercised4 years after start, or upon liquidity eventStart date
Cash Cost at Exercise$10,000 + AMT tax1$0
Liquidity Event Share Price$100$100
Tax Rate at Sale40%220%3
Total Exercise Cost$10,000$11,5934
Total Taxes Paid$396,000$197,681
Total Value to Employee$594,000$790,726

 

1 Can be in the tens of thousands of dollars

2  Assuming no post-exercise capital gains

3 If 5 year hold and certain conditions met 0%

4 Assumes $1,593 in interest

Upon hiring: We provide employees with the option to early exercise. This provides the ability to exercise their options immediately, in advance of vesting. By exercising early and filing a 83(b) election with the IRS, employees are able to significantly lower their tax burden. This option is not exactly common but also not unheard of in the startup space.

More uniquely, our program also allows employees to exercise without putting up any cash upfront. Instead, we offer a loan at the lowest interest rate permitted by the IRS and employees can exercise with their borrowed funds with just a promissory note.

If they leave before a liquidity event: If an employee leaves before a major liquidity event but after their options have vested, there’s no purchase necessary if they took advantage of the early exercise in advance.

If a liquidity event happens: Whether upon an IPO or acquisition event, employees will be paying less in taxes. Gains on stock held for more than a year before a sale is considered long-term for tax purposes and can be taxed at approximately half the rate. Additionally, if held for 5+ years, it can, with some qualifications, be tax free up to $10M from federal taxes.

Our Mission to Help People Optimize their Wealth

Harness Wealth created this unique employee benefit because we’re committed to helping people grow their wealth, and that starts right here at home for the people on our team.

Helping employees more easily profit from the company’s success is one of the best ways to compensate and reward them fairly. While ping pong tables and other flashy benefits may get more attention, we believe offering benefits that lead to overall financial wellness are truly the most valuable — and relevant to our business’s mission.

You can learn more about the Harness Wealth team and see our open positions on our About Us page.