When determining the compensation packages for employees, early stage companies must be able to balance their need to recruit and retain top-level talent while maintaining reasonable expenditure levels so that they can devote their available cash resources to the growth of the company. One solution used by many early stage companies is the use of employee stock option ("ESO") incentives for employees, in addition to traditional salary packages. Further benefits of offering ESOs are that they can have the effect of creating alignment in the interests of the company and the employee, and they may provide additional tax benefits to the employee.
An ESO is an option granted by the company to the employee, allowing the employee to purchase equity shares in the company at a certain price (the "Strike Price"), which is typically set at or above the current market value of the company's shares at the time of the grant. The employee can exercise ESOs that have become fully vested in them at any time up until the expiry date of the ESO, which is typically several years from the date of grant. The ESO increases in value to the employee as the company grows, and the market value of the company's shares begin to exceed the Strike Price at which the employee can acquire those shares. Essentially, through the ESO, the employee becomes an investor in the company, but can delay their cash outlay and their exposure to the downside risk of the company shares until the time of their choosing. The company gets the additional benefit of the cash received each time an ESO is exercised.
There are many different options available to the company to provide it flexibility and customize the terms and conditions on which ESOs are granted to or exercised by employees – these are usually set out in the company's stock option plan, or through additional agreements such as a reverse vesting agreement. Examples include creating a vesting schedule such that the employee is only able to exercise some of the ESOs granted after certain milestones are achieved, or allowing the company to repurchase the employee's shares at a nominal price if the employee quits or is terminated before a certain date. These types of arrangements help increase the retention of key employees by creating an incentive for them to continue working with the company.
A further benefit of granting ESOs to employees instead of additional salary is that, in certain circumstances, they can provide tax advantages to the employee. When an employee is granted an ESO, the difference between the Strike Price and the market value of the company's shares at the time the ESO is exercised is a taxable benefit to the employee, which must be included in their income for the year. However, if the company qualifies as a "Canadian Controlled Private Corporation" under the Income Tax Act (Canada), any tax implications may be deferred until the employee decides to sell their shares. If certain additional conditions are met, the employee may even be eligible for a tax deduction equal to one half of the benefit received.
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