Issuing And Receiving Options

Stock options can be a great way to incentivize and reward workers. Here are the key considerations for issuing and accepting them.

Options can help companies attract and retain employees, consultants, officers and directors while preserving capital. Receiving options can help workers feel invested in their organization, and can offer the chance to share in their company's future growth.

Here's what to keep in mind if you are considering issuing (or accepting) options.

What are options?

A stock option, often referred to as simply an "option", is a right to acquire stock, or shares, of a company.

Options typically allow the holder to purchase shares of a company for a certain period of time into the future, at an "exercise price" set now (even if the fair value of those shares increases later on).

For example, a company whose shares have a fair value of $1 per share today might issue 100 options with a term of five years to a worker with an exercise price of $1 per share. In five years' time, the fair value of that company's shares may have risen to $5 per share. But the worker retains the right to purchase shares from the company for only $1 per share up until their options expire. In this situation, the options are commonly referred to as being "in the money."

If the worker exercises their options, the worker pays the company $1 per share but receives shares worth $5 each, and therefore receives $4 in extra value for each of the 100 shares they acquire – $400 in total. That value can turn into cash if the worker ultimately sells their shares or if, in the context of a merger or acquisition transaction, such in-the-money options are redeemed or purchased for the cash value.

Some options may be immediately exercisable, while others "vest", or become exercisable, over time or upon the achievement of certain milestones by the worker.

Begin with tax advice

The issuance, vesting and exercise of options, as well as the sale or other disposition of any option shares acquired on exercise of options, can have tax consequences both for the issuing company and the recipient. The tax treatment of stock options depends on the status of the company, the status of the recipient, and the terms of the options and underlying shares, among other things. It is possible for employees, officers and directors to obtain capital gains-like tax treatment in connection with stock options in certain circumstances.

A company considering issuing options should get tax advice before discussing the issuance of any options (or any other securities) with potential recipients. Verbal conversations can easily lead to misunderstandings and serious legal issues later on. Further, a company may have tax reporting, withholding and remittance obligations in connection with options which must be complied with in order to avoid the potential application of interest and penalties.

Ensuring there are no tax or legal hurdles to issuing the options beforehand, and having the right information on hand when you discuss options with a worker, can help set everyone's expectations accurately.

If you are the proposed recipient, or are considering accepting options as full or partial compensation for work performed, you should also get tax advice to understand any consequences of doing so and whether any amendments to the terms may be required such that the options are structured more favourably for you. Consider also how the exercise price and any applicable tax withholdings will be funded.

It may be desirable to implement changes to the company's capital structure before implementing an option plan, such as creating a class of non-voting shares or putting in place a shareholders' agreement or voting trust agreement (see "Shareholders' Agreements and Voting Trust Agreements" below), in each case to manage the rights of the new shareholders. These changes could have tax implications, so should be explored with the benefit of both corporate and tax advice.

Options vs. Alternatives

Options are a popular type of security for both companies and their workers, in part because of favourable tax treatment they can receive. However, you may wish to consider the following alternatives just in case any of them better suit your objectives. Your particular situation may also be best addressed through a combination of option grants and one or more of the following alternatives:

• Cash bonuses or profit sharing arrangements. Cash may be simpler and faster for a company to issue, and could be a preferred form of compensation by the recipient. Its value is certain, and does not depend on the future growth of the company or the recipient's ability to sell their shares. Moreover, the recipient is not granted a right to potentially become a shareholder of the company. Among other benefits, such as retaining more ownership and control of your company and potentially reducing the issue of dealing with minority shareholders, disbursing cash can make it easier for the parties to cut ties in the future, if need be. Companies can also generally get the benefit of corporate tax deductions on cash bonuses and profit sharing arrangements.
• Phantom equity. Phantom equity generally refers to contractual rights or interests that economically track the value of shares but are not in fact equity, and thus do not provide the recipients with shareholder rights. There are numerous types of phantom equity, including restricted share units, performance share units, deferred share units and share appreciation rights. Canadian tax advice should be sought when considering phantom equity as there are subtle differences in the tax treatment of each form of phantom equity.
• Reverse vesting. In a reverse vesting scenario, a person purchases shares outright, but the company can repurchase those shares for the same price later on if certain conditions or milestones are not met. This provides a worker with a full stake in the company on day one (unlike options, which don't turn into shares of the company until they are exercised), but also empowers the company to essentially take those shares back later on if things don't work out. Using reverse vesting can help a recipient feel more invested in your company from the outset, and works particularly well when a company is newly formed and the fair value of its shares is nominal (this can make it easier for the recipient to buy the shares in the first place, and requires less capital from the company if it ever needs to buy them back at the original issue price). If the company is more established, however, the fair value of the shares may be higher and it may be more of a challenge for the recipient to initially pay for their shares. Moreover, if you don't already have a shareholders' agreement in place, you should give serious thought to having one prepared before bringing another shareholder into the picture (see our Legal Guide about shareholders' agreements, and "Shareholders' Agreements and Voting Trust Agreements" below). There may be adverse tax treatment to reverse vesting shares, so companies and recipients should consult with a tax advisor in advance of implementing a reverse vesting arrangement.
• Shares. You may prefer to issue shares to your recipient outright. There are a number of considerations involved with issuing equity, however:
  • As with reverse vesting, you should strongly consider putting a shareholders' agreement in place before issuing any shares.
  • In addition, corporate statutes require that shares can only be issued for cash, or in respect of past services which have already been performed for the company, so shares cannot be issued in anticipation of future work.
  • Where shares are to be issued for past services, corporate law requires that directors make a determination that the company has received at least the same value of services as the dollar value of the shares being issued. A company will also need to consider how much to add to stated capital in connection with the issuance.
  • There may be tax consequences if shares are issued for a price other than their fair market value, so tax advice should be sought at an early stage if cost may be an issue.

Often, it is simpler to pay the worker in cash and for the worker to then use that cash to subscribe for shares, if desired. Companies sometimes consider providing loans to employees to fund the subscription price, but tax advice should be sought in advance of extending any such loans.

How options are granted: option plans vs. other agreements

An option plan can help a company issue options efficiently over time. Generally, an option plan is adopted by way of board approval, although sometimes shareholder approval is sought. An option plan will contain many of the terms and conditions for options, such as exercise procedures and termination provisions. The company and the worker would then sign a simple option or grant agreement that incorporates the terms of the plan and sets out the details of the options being issued to the worker, such as the number of options, exercise price, and any vesting conditions.

Options can also be granted by standalone option agreements which contain all of their own terms and conditions, or provisions providing for option grants can be included in employment or consulting agreements.

Keep an eye out for overlap and inconsistency between standalone agreements and option plans. In Fuller v. Aphria, the Ontario Court of Appeal found that the expiration date of some options set forth in a consulting agreement prevailed over the general termination provisions in a company's option plan, based on the interpretation of those two specific documents. To reduce the risk of uncertainty later on, keep vesting and termination provisions clear and consistent.

Shareholders' Agreements and Voting Trust Agreements

If your corporation has a shareholders' agreement in place, you may wish to have an optionholder become a party to that agreement before acquiring their options. That way, if they later exercise those options to become a shareholder, they are already a party to the agreement. See our Legal Guide about shareholders' agreements for more information about these types of agreements and why it may be desirable to have one in place. Shareholders' agreements may contain terms that preclude the advantageous tax treatment often available in respect of options, so a tax advisor should be engaged to review any applicable shareholders' agreements where an option plan is contemplated.

A voting trust agreement essentially functions to assign the voting power over certain shares to another person (the voting trustee). The shareholder retains all of the other rights and benefits associated with the shares, including the right to receive dividends, but the company does not need to worry about collecting their votes or signatures on shareholder resolutions. A voting trust agreement can be particularly effective in combination with an option plan to avoid giving rise to a large number of minority shareholders from whom to collect signatures.

To whom can you grant options?

Options are commonly granted to directors, executive officers, employees, and "consultants" of a company. Section 2.24 of National Instrument 45-106 provides a specific prospectus exemption for these groups, subject to certain conditions.

To be considered a "consultant", a person must provide services to the corporation or a related entity pursuant to a written agreement, and must spend a significant amount of time and attention on the business and affairs of the corporation or a related entity. Note, however, that consultants are not eligible for the favourable tax treatment often available in respect of stock options.

Options may also be granted to a variety of other recipients so long as an appropriate prospectus exemption is available.

Other Important Considerations

For any company creating a plan and issuing options, it will be critical to make sure that all steps are properly recorded in the corporate records. Accordingly:

• Keep track of key dates and keep your minute book updated accordingly.
• Record when the option agreement was signed, when the options vest, and the outside date of when they expire. This information may be set out in the option agreement or in other documents such as an employment or consulting agreement. Consider the potential impact of a change of control or termination of employment.
• Ensure your company maintains a register setting out the details of the holders and securities outstanding, as required by the corporate statute. See our blog on the importance of maintaining your minute book.

Where a publicly listed company is involved, consider also:

• the rules of the applicable stock exchange regarding shareholder approval for security-based compensation plans and option issuance limits, and
• compliance policies and blackout periods that restrict an optionholder's ability to exercise their options or resell their shares.

Key Take-Aways

• Speak with a lawyer and tax advisor before raising the topic of options, or any other securities, with any potential recipient. Options can be subject to favourable tax treatment, but only when certain conditions are met. It may also be that a different (or additional) form of award or bonus is best suited in your particular circumstances.
• When you discuss options or any other securities with a potential recipient, clearly state the number of options and any vesting conditions attached to them, and document the conversation as much as possible. If the options are being provided under an option plan, provide the recipient with a copy of both the option agreement and the option plan for them to review with their legal and tax advisors. Be clear about what class of shares the optionholder can acquire on exercise of the options, and any other expectations you have (such as that the optionholder will become a party to a shareholders' agreement or a voting trust agreement, or will need to qualify under a particular prospectus exemption).
• Make vesting conditions and termination events clear and objectively verifiable. For example, instead of a requirement that the recipient prepare a business plan, consider instead that the recipient produce a business plan that is approved in writing by the company's board of directors, so that it can be independently confirmed whether or not those options have vested. Keep an eye out for any inconsistency between your option plan and any options granted by way of a standalone agreement, whether before or after the adoption of the plan.
• Ensure that the company's corporate records are updated immediately following the issuance or exercise of options.
• Ensure the company complies with any applicable tax reporting, withholding, and remittance obligations in connection with stock options and other awards.

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.