Blog: Stock Options in the Technology Sector – the Good, the Bad and the UglyFebruary 15th, 2016
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 reasons:
- 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 account.
- 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 well.
- 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 retention.
- 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 plans.
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.
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