Employee stock options (ESOs) are a popular form of compensation among start-ups, particularly in the technology sector. Options grant employees the right, but not the obligation, to purchase company shares at a predetermined price, often vested over a period of 3-4 years. This setup aligns the interests of the employees with those of the company, fostering a shared commitment to the organization’s growth and success.
ESOs serve as a valuable tool for attracting and retaining top talent. They offer employees a tangible stake in the company, incentivizing long-term commitment. For employers, ESOs can be a cost-effective way to compensate employees, especially when cash flow might be limited. This is particularly relevant in the early stages of a technology company’s lifecycle, where rapid growth and scalability are key objectives.
Mutual Benefits for Employers and Employees
From an employer’s perspective, ESOs can be instrumental in building a motivated and dedicated workforce. They also help in maintaining a competitive edge in the job market. For employees, these options represent a potential for significant financial reward, should the company’s value increase. This dual benefit creates a synergy between employer and employee goals, fostering a culture of ownership and collaboration.
Legal Framework
In Ontario and across Canada, ESOs are subject to legal and regulatory frameworks. Corporate, securities and tax laws are the main areas to consider.
Aside from the main areas of governing law, careful consideration should be given to what class or type of shares are granted pursuant to the plan. Often employees are granted a separate class of shares under the plan which carry different voting and dividend rights. The share class may also have a lower preference on the return of capital in the event of insolvency.
If employees were granted a class of voting shares, for example, the same class of common shares as the founders, it could have a material impact on control and governance of the company. For example, if two founders held 50% of the company, the first employee who exercises options would have the ability to break a tie vote at the shareholder level. For a more detailed discussion on control, see the section above on founder agreements.
For many employees, the overall deal can be difficult to understand. You will face questions about what percentage of the overall equity the employee is being granted. Questions like that can be tricky to respond to simply because the number of options they receive will be fixed, but the number of shares outstanding in the company may vary over the term of the employment relationship. This means that the percentage of equity held may fluctuate. I typically try to have clients avoid discussing percentages for that reason, and focus on the number of shares subject to the option and the then current number of shares outstanding.
Careful consideration related to the disclosure of the overall deal to employees should be undertaken as well. While each employee should have their own lawyer review the terms of the employee stock option plan, option grant agreement, employment agreement, etc., seek your lawyer’s advice on disclosing a summary of the plan, agreements and issues like (among others):
- The exercise price to acquire shares under the option agreement.
- The vesting period.
- Trigger events that stop the vesting period, including in relation to the cessation of the employee’s employment.
- The options and shares not being transferable.
- The company not being a public company and there being no public market to sell the employee’s shares upon exercising the option.
- It may be difficult for the employee to assess whether to exercise any stock options before they expire and what the fair market value of the company’s shares are at the time the employee decides to exercise.
- Whether there are provisions that can force the employee to sell their shares back to the company, or to a third-party, for example, if the company is being acquired.
- There being no guarantee that the employee will see a return on their investment in purchasing shares in the company and the employee may lose all of their investment.
- Additional employee option grants, and the issuance of any additional shares in the company, will have the impact of diluting the employee’s options (or any shares the employee purchases).
- There may be significant taxes the employee will be required to pay in connection with the options and/or the sale of shares once the option is exercised.
Tax Implications of Employee Stock Options
There can be negative tax implications for Canadian companies and the employee stock option plan participants, often arising from three main considerations (although there are many other considerations your accountant and lawyer can advise on): (i) whether the company is (and remains) a Canadian controlled private corporation (“CCPC”), a status defined by tax laws; (ii) whether options were issued at fair market value to the participants; and (iii) whether the participant is a contractor or employee.
CCPC Status
At the time of writing, being a CCPC can significantly impact the taxation of stock options. For Canadian employees of a CCPC, a key benefit is the deferred taxation on the employment benefit associated with the grant or exercise of stock options. Instead of being taxable at the time of exercise, as may be the case with public companies or non-CCPCs, the taxable benefit for employees of a CCPC may be able to be deferred until the options are exercised and the shares are actually sold. This deferral aligns the tax liability with the realization of actual economic gain (i.e. you actually receive cash for the sale of your shares), offering a liquidity advantage to employees.
However, this favorable treatment may be subject to specific conditions, underscoring the importance of seeking legal and tax advice in your specific circumstances.
Fair Market Value of the Options
Issuing options for an exercise price below fair market value can carry tax implications as well. For example, when employees are issued shares at a price below the fair market value, the discount they receive may be considered a taxable employment benefit. The tax on the benefit may also be payable at the time of exercise, rather than the time in which the shares are sold. More importantly, the benefit may be taxed as employment income, not as a capital gain. Consequently, the benefit is taxed at the employee’s marginal tax rate, which is typically higher than the capital gains tax rate.
Contractors vs. Employees
Perhaps the most important consideration is whether the recipient of the option is an employee or not. At the time of writing, the tax implications for contractors receiving stock options can be notably less favorable compared to employees. Typically, contractors may face immediate tax liability upon receiving the options, rather than deferring the tax until the options are exercised or the underlying shares are sold, as can be the case for certain employees.
This immediate taxation occurs because the benefit from the stock option grant is considered income for a contractor, taxed in the year the options are granted. This immediate tax burden can create cash flow issues for the contractor, as they incur a tax liability without a corresponding immediate cash gain. That is, in a private company, the contractor receives an option to purchase shares, and once the shares are purchased, they are illiquid, not easily sold. So, the contractor could be left footing the tax bill, even though all they have is illiquid options or shares.
Employees, however, under certain conditions, may be able to realize the tax liability in tandem with either the exercise of the option, or the sale of their shares (rather than the date upon which the options are granted).
Additionally, contractors may not benefit from certain other tax deferrals or reductions available to employees. These factors make stock options a potentially less attractive form of compensation for contractors and require careful tax and legal advice if pursued.
Personally, I disagree with the tax policy that leads to granting options to contractors less favorable, and in most cases, not practical. In my view, options granted to Canadian contractors of a CCPC should only be taxable when the contractor actually exercises their options and subsequently sells their shares. This would make the operation of early-stage start-ups (who sometimes lack the budget to hire full-time staff) much easier.
As I am sure you can appreciate from the above sections (only covered in a very short form), the taxation of stock options (and their subsequent exercise and sale of shares) is complex and outcomes can vary dramatically based on various factors such as the type of option, the exercise price, the participant’s status with the company and the timing of the sale of shares.
There can be other serious tax considerations that tax advisors can advise you on at the time your employee stock option plan is created, and when you are considering the award of options to participants. Again, seek legal and tax advice in connection with the creation of a stock option plan and the granting of any options under the plan.
DISCLAIMER: The information in this article is not (and is not intended to be) legal advice. This is legal information only. Reviewing information about the law may help you understand whether you need legal assistance. Whether and how this information applies to your circumstances requires the assistance of legal counsel who can apply the information to your needs. Do not rely on this article to make decisions. You may contact Wires Law, and we would be pleased to determine whether our firm can assist you. No solicitor-client relationship is established until we confirm we can act for you in a legal services agreement. Read our Terms of Use for more information.
John Wires
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