Stock options are an often-used employee incentive in the tech
sector. The options grant employees the right to buy shares of the
company at a predetermined price, allowing them to participate in
its future growth. There is no obligation for employees to exercise
their options. The options will often vest over a period of time,
rewarding employees for their loyalty.
Stock options are a great compensation tool for a few
No cash outflow. For a start-up company, cash
burn-rate is a key item to manage. By granting stock options, you
can compensate your employees more without draining the bank
Motivates employees. You often hear the reason
for this in Westjet ads as "Because owners care." The
goal is to align an employee's interests with the
company's. The employee will be motivated to make the company
more profitable, as they will be better off financially as
Talent attraction. Tech companies that offer
perks such as stock options will be more attractive to talent.
Retention. Stock options plans encourage
employees to think long-term about the company, increasing
Potential for cash inflow. Employees
exercising their stock options will actually be contributing cash
to the company.
When employees exercise their options, they become shareholders.
They then have certain rights, depending on the type of shares
issued and the company bylaws.
This can include voting and attendance at annual general
meetings, receiving audited financial statements, and entitlement
to dividends. While you may trust your employees to not cause
shareholder disputes, what happens if they leave the company? What
happens if they sell their shares? A shareholders agreement can be
a very useful document to manage these types of situations. Keep in
mind that you are not just giving up a percentage of the pie,
you're giving up a portion of control too.
Determining the exercise price for the options can be tricky. If
the price is too high, employees won't be motivated as they
might see it as unattainable. If the price is too low, the stock
option's incentive power is reduced as the reward is all but
guaranteed. There are also tax rules that encourage granting
options with an exercise price that is at least equal to the fair
market value of the company's stock at the time of issuance. If
you're raising financing by issuing shares, you might have a
good idea of the company's value. Otherwise, how do you really
know how much the company is worth in order to decide an
appropriate option price?
Stock options also come with a fair amount of administrative
work. The stock option plan and agreements need to be created and
approved. Options granted, vested, exercised, cancelled and expired
all need to be tracked as well.
One thing that is often overlooked by employees receiving the
options is in order to realize any benefits of the options, they
have to pay the exercise price to receive the shares. When the
shares are not easily resalable, this can tie up their cash. As
such, employees are not as inclined to exercise options unless they
can see a potential payout via an IPO or private purchaser.
So how does all this affect tax and financial statements at the
end of the day? The company's taxes are unaffected. It gets no
deduction for stock options granted, vested or exercised.
The employee gets taxed on the options, but in a somewhat
favourable manner. There is no taxable benefit when the options are
granted or vested. When the options are exercised, there is no
immediate tax to pay if the company is a Canadian-controlled
private corporation. The tax gets deferred until the employee sells
the shares. Generally speaking, when shares purchased using stock
options are sold, the employee gets a deduction of half of the
taxable benefit on the option (fair value when exercised less
exercise price), as long as:
a) the exercise price was equal to or greater than the fair
value of the stock when the option was granted, or
b) the employee holds the shares for at least two years if the
company is a Canadian-controlled private corporation.
Note: The current Liberal government has announced
its intention to limit the half deduction. No legislation has been
issued yet with respect to this proposal but it is anticipated that
the new rules will only impact employees with more than $100,000 of
annual stock option gains and will not impact existing stock option
For financial statement purposes, options that vest in the year
are reported as an expense. The value of the options is estimated
using mathematical models, such as Black-Scholes. Financial
statements must also disclose various details on the stock options
issued and outstanding.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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Unfortunately, reasonable accommodation for employees in the workplace continues to be the source of significant litigation and even today we continue to see outrageous examples of employers behaving badly.
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