Fixing employee compensation is a balancing act between the interests of the employer and employee. Employers wish to attract the best talent they can and incentivize them to work their hardest to further the aims of the business. Employees wish to be fairly compensated for their work and share in the successes of the business that they contribute to.

Compensation can take many forms, from monetary compensation (i.e. salary or an hourly wage) to complex equity arrangements.

One of the most common forms of equity compensation is stock options granted to an employee by an employer under an employee stock option plan (“ESOP”). ESOPs can be potentially very lucrative for employees and provide employers a powerful tool for aligning the interests of its employees with the success of the business. For startups, ESOPs can be a great recruitment tool because it gives potential employees the opportunity to enjoy the benefits of a successful startup’s rapid growth while potentially helping the start-up retain cash.

What is an ESOP?

ESOPs are the framework under which employers issue options to employees. Individual option agreements are issued under the ESOP, governed by the ESOP, and a template option agreement is typically attached to the ESOP.

Option agreements provide employees the right to purchase shares of the employer corporation at a specified price during the term of the agreement, and subject to specified “vesting” provisions and other conditions. ESOPs work by granting employees the opportunity to benefit from a higher future value of their company’s share price.

It is worth noting that an optionholder (i.e. an employee who has received an option) generally does not receive the rights of a shareholder until the option is exercised and the underlying shares are purchased.

Here’s an example: Emily is an employee of XYZ Corp. As part of Emily’s compensation, she is granted an option to purchase shares of XYZ Corp at the current fair market value ($1) for up to five years from the date the option is granted (we are ignoring vesting conditions in this example). Four years later, the fair market value of the shares of XYZ Corp is $100/share. Emily then exercises the option to purchase 100 shares at $1/share, for a total of $100. However, the fair market value of the shares at that time is $10,000, meaning that Emily received a benefit of $9900.

Four concepts are important to understanding how ESOPs work: the option pool, the exercise price (or strike price), the term, and the vesting conditions.

The Option Pool

The option pool refers to a portion of the employer company’s shares that can be awarded under options to employees. The ESOP may set out both the number of the shares in the pool (in fixed or percentage terms) and the class or classes of shares it will contain (though this may be left to the board’s discretion).

The shares reserved for the option pool are notional: they are authorized shares of the company but are not issued. In other words, these shares are unowned and generally do not directly affect the current shareholders’ ownership of the company until they are awarded. Moreover, until the shares in the option pool are actually purchased, they cannot be used for any purpose except that provided by the ESOP.

The Strike Price

The strike price refers to the price the employee pays per share when they exercise the option.

Typically, the strike price represents the fair market value of the shares at the time the ESOP is granted. The strike price is usually not less than the FMV, as this may be prohibited by the rules of the stock exchange on which the shares are listed (if the company’s shares are listed on an exchange) or the corporation’s constituting documents.

It is generally important for employers to ensure that the current FMV of the company’s shares are properly assessed whenever an option is granted. It is also important for employers to carefully consider the strike price before granting options to its employees; a low strike price may have adverse tax consequences for the employee or the employer, while a high strike price may decrease the benefit to the employee.

The Term

The term refers to the period in which the option to purchase the shares at the strike price can be exercised.

The term of a stock option is generally five to ten years from the date of grant. This is subject to any rules by applicable stock exchanges, in the case of a listed corporation. Once a term expires, the option is forfeited by the employee.

ESOPs also generally address the consequences of an employee leaving the employer, whether as a result of resignation, retirement, or termination of employment.

The Vesting Conditions

“Vesting” is a legal term which means to give or earn a right to a present or future payment, asset, or benefit. For ESOPs, the agreement that grants the employee the option will generally provide that the option cannot be exercised until certain pre-conditions are met. A common vesting condition is when an employee has worked a certain period of time and/or certain performance milestones have been met. The vesting conditions can be structured such that all or some of the option granted vests at the end of a certain period (this is referred to as “cliff vesting”) or in tranches over a certain period (referred to as “graded vesting”). Carefully tailoring the vesting conditions in an ESOP can be an effective means to incentivize employee performance and increase employee retention.

Tax Considerations

The tax rules applicable to equity compensation are complicated and depend upon the financial circumstances of the employer and employee. Employers and employees should consult tax professionals when assessing options.

The Canadian Income Tax Act includes rules for stock options that may reduce the tax burden for employees in certain circumstances.

In particular, stock options may not be taxed in the taxation year that they are received. Instead, they may only be taxed when they are exercised, meaning that the tax implications of stock options are deferred on the grant date. Moreover, the employee is generally only taxed on the difference between the FMV of the shares at the date the shares are purchased and the strike price. Employees may also benefit from two separate 50% deductions that may be claimed by employees in certain circumstances. 

Subject to certain conditions, when an employee purchases shares through an option agreement granted by a Canadian controlled private corporation (“CCPC”), that employee can benefit from a further tax deferral: the taxable benefit is not included in the tax year in which the shares are received by the employee, but rather the tax year in which the shares are sold. (You can learn more about the CCPC classification here).

Non-employee stock options

This article has focused on options granted to employees, but stock options can also generally be granted to non-employees, such as directors or independent contractors. However, businesses should be aware that different legal and tax considerations apply in these circumstances. 

If you need someone to review your business’s existing ESOP or draft a new one that is tailored to the needs of your business, let’s chat!