Usually you need the cash to buy shares—maybe more than you can afford to pay at exercise time. Another, less common approach to be aware of is for companies to allow the person exercising options to avoid paying the cash up front and instead accept a promise of payment in the future.
Definition A company may accept a promissory note to exercise compensatory options. Essentially, a promissory note is like giving an “IOU” to the company instead of paying the company cash for shares. The note may either be a recourse promissory note or non-recourse promissory note. “Non-recourse” means the lender (the company) is prohibited from seeking a deficiency payment from the borrower (the recipient of the stock) personally if they do not pay; they only can foreclose on the property itself (in this case the stock).
technical The tax consequences to the company and the optionee depend on how the note is structured. If the note is non-recourse, for state law purposes the company will consider you an owner of the shares received in exchange for the non-recourse note, but the IRS will consider the shares still an option until the promissory note is paid (which would also affect timing for long-term capital gains).
technical Non-recourse promissory notes can also be used to extend option windows on stock options that are expiring (for example, after 10 years), while not requiring the holder of the options to pay until later, when the stock may be liquid or have higher value.
Of course, use of promissory notes is complex and entirely at the discretion of the company. Individuals considering the idea should discuss with a lawyer as well as the company.
Less Common Types of Equity
While most employee equity compensation takes the form of stock, stock options, or RSUs, a complete tour of equity compensation must mention a few less common forms.
DefinitionPhantom equity is a type of compensation award that references equity, but does not entitle the recipient to actual ownership in a company. These awards come under a variety of different monikers, but the key to understanding them is knowing that they are really just cash bonus plans, where the cash amounts are determined by reference to a company’s stock. Phantom equity can have significant value, but may be perceived as less valuable by workers because of the contractual nature of the promises. Phantom equity plans can be set up as purely discretionary bonus plans, which is less attractive than owning a piece of something.