Employee Stock Options: Everything Canadian Business Owners Need to Know
DISCLAIMER
This information is intended for business owners in Canada and serves as general guidance only. Always consult with a qualified advisor before making any legal decision.
IN THIS ARTICLE, WE’LL COVER THE FOLLOWING TOPICS:
What’s a share?
What’s a stock option?
Why employee stock options are useful
The best time to use an employee stock option plan
How much to put into an employee stock option plan
Tax consequences of employee stock option plans
What happens to employee stock option plans if a company is bought
What happens to employee stock option plans if an employee is fired or quits
What’s a share?
In the most basic terms, shares represent an ownership stake in a company. For example, let’s say a company has 100 shares. That means there are 100 ownership stakes in the company – each share representing a one percent ownership stake in the company. Note in Canada we generally use the term ‘shares’, while in the US the term ‘stock’ tends to be more commonplace. They mean the same thing.
What’s a stock option?
Let’s use the same example – one company, 100 shares. If you have a stock option of that company, you have a right to purchase one of those shares at a later date. Having a stock option does not mean you are obligated to purchase shares; it simply means you have the ability to purchase a certain amount of those shares. Despite the Canadian tendency to refer to ‘stock’ as ‘shares’, we don’t use the term ‘share options’.
Typically, stock options will have what’s called a strike price (also called an exercise price); this price is usually (hopefully) below market value, incentivizing the owner of the stock option to purchase an ownership stake (stock share) of a company.
To use another example, let’s say I was just hired by Apple and that one share of Apple is $200, and that I was given a stock option, worth $1, that entitled me to one ownership stake of Apple. In this example, the gap between the strike price and the actual price of the share is $199 – an exceptional bargain that not only grants me an ownership stake in Apple for a fraction of the cost that most other people would pay.
Why are employee stock options useful?
The best thing about employee stock options is that they allow your company to align employee incentives with owner incentives. In other words – they’re good for business.
Essentially, by giving your employees stock options, you’re making them quasi-owners of the company, then eventually full-fledged owners of the company once they convert those options to shares. This encourages your employees to adopt a business owner’s mindset, to think about the long-term, and to generally treat the company as if it were their own – because it is.
Employee stock options also help build loyalty among your employees by locking them into an agreement in which they get some of the stock options after 365 days of employment, some in year two, year three, and so on. This is known commonly as a cliff and vesting period.
With the cliff period, the idea is that the employee receives no shares until the cliff period has elapsed – typically after one year of employment. Once the cliff period expires, the employee will receive 25 percent of the options on that date. Thereafter, the rest of the options will vest over the next three years - 25 percent in year two, another 25 percent in year three, and so on. They could also vest on a monthly basis. Once they reach five years of employment, they’ll have received 100 percent of their stock options and can exercise those options whenever they want, as long as it’s before the options’ expiry dates.
What’s the best time to use an employee stock option plan?
In general, employee stock option plans work best for companies after the first round of financing has closed, but before the company has started a major hiring initiative. It’s important to remember that while employee stock options allow companies to add much-needed structure to their equity offerings, they should be approached thoughtfully – you don’t want to put yourself in a position where you’re doling out too much equity to employees.
How much should I put into an employee stock option plan?
It could be as little as five percent or as much as twenty-five percent of your company. To determine what’s best for you, you’ll need to consider two things: your industry and the importance of key employees to your company.
For example, if your company’s founders are pivotal to the business – the success of the company hinges on their level of involvement and decision-making – while most other employees fill back-end administrative roles, then you likely won’t be handing out large chunks of equity to your employees.
On the other hand, if your company’s founders take more of a back-seat role, letting others take the wheel – then it stands to reason that your employees, who are so critical to the success of your company, should receive more equity.
As a general rule of thumb, the first ten employees of a startup can expect to receive around ten percent of the company’s equity, the next ten employees receive five percent, the next 50 employees receive 5 percent, and so on. The first employees tend to get more equity, as they often hold the most important roles in the company.
What are the tax consequences of an employee stock option plan?
If your company is a Canadian-controlled private corporation (CCPC) – which most Canadian private companies are – then rest assured, there are no tax consequences for setting up an employee stock option plan, nor are there consequences for the employee who receives those stock options. With employee stock options, taxation only occurs when the employee converts the options to shares.
Let’s say an employee has one stock option worth $1, and the company’s stock price is $10. If the employee were to exercise their option, they would pay tax on $9.
Keep in mind that built into the Canadian tax code is something called a deferral mechanism, which may permit employees to defer the recognition of that gain to the point in time when they sell the shares in the company - however your company and the employee in question should obtain tax advice to ensure that they are eligible for this deferral.
What happens to my employees’ stock options if my company is bought?
In general, the first thing that happens is that outstanding employee’s stock options are automatically vested upon acquisition of the company, meaning that the typical vesting period – anywhere from 1-5 years – immediately accelerates, allowing employees to exercise their options as they wish. Before the company is bought, most employees will need to wait to convert their options to shares; after the company is bought, they can do so immediately.
What happens to my employees’ stock options if my company fails?
If your company fails, your employees’ stock options become worthless.
What happens to an employee’s stock options if they are fired or quit?
If an employee has stock options that have not yet been vested, and the employee is fired or decides to quit, they forfeit those options.
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