Stock Option Plans 101: A Guide for Businesses and Employees

What Is A Stock Option?

Employee stock options are a form of compensation that allows an employee to purchase shares at a pre-determined price. Various startups and companies include this as part of their employee compensation plans. 

 

A stock option may often be mistaken for a percentage of shares of the stock. It is the right to buy a certain percentage of shares at a fixed rate. These rates may be attributed to other aliases such as grant, strike, or exercise prices. Such a plan tends to benefit those with this right because they can buy these shares at the preset prices even when the share prices soar, enabling them to profit from the margins of difference. 

 

ESOPs are choices given to employees as a right and not an obligation. They are essentially set up as trust funds and can be funded by companies by putting freshly issued shares in them. When a fully vested employee leaves the company, the vested shares are purchased back from them. In return, they are paid in lump sum or equal periodic payments.

 

Also Read: Force Majeure in Contracts: A Guide for Ontario Businesses

What Are The Types Of Stock Options Plans?

1. Incentive Stock Option (ISO)

An ISO, or statutory stock option, is a form of equity compensation that allows employees to purchase the shares of their company at a discounted price. ISOs receive special tax treatment if held for at least one year after exercising the option and two years after the grant. However, sometimes, the holder of an ISO may be subjected to alternative minimum tax (AMT) in the year that the option is exercised.

 

ISOs are often issued by publicly traded or private companies planning to go public. Under this category, employees given this right must exercise their options within a particular period.

 

These options are also commonly known as SARs (Stock Appreciation Rights). Employees must track some important dates regarding their ISOs, including the grant date—the date the shares are allocated and determined by exercise prices—the vesting date—when the ISOs become available—and the expiration date. 

 

2. Non-qualified Stock Options (NSO)

NSOs are typically simpler than ISOs. Like ISOs, the option has a deadline before the expiration of which they must be exercised. These options are often provided by companies with the presumption of prices increasing over time. It is the preferred form of option by employers, as they are both, compensation and incentive for employees to work to yield better results. Through this type of option, employers benefit from NSOs because it minimizes the cash outflow, allowing increased cash and liquidity retention.

 

NSOs require employees to pay taxes at two stages; when options are exercised and when the shares are sold. That is, they are not qualified for any tax-advantaged treatment like ISO. They can also be issued to various non-employee service providers such as consultants, advisors and independent board members. Although both NSO and ISO seem similar, they are differentiated by the way and time at which they are taxed. 

 

Moreover, you must know that if you exercise your NSO and hold the stock, you may be eligible to avail of the Qualified Small Business Stock (QSBS) tax benefit. This benefit allows you to sell your shares without being taxed at the sale if you hold them for a minimum of five years.

 

3. Phantom stock

These options may be awarded upon reaching performance targets. Phantom stocks provide the benefits of share ownership without having to legally, issue shares. 

 

This is a compensation where a cash bonus is correlated to the value of a specific number of shares and are considered as a type of deferred employee compensation plan. They are of different types:

• ‘Appreciation only’ phantom stock plans: This is where the employee receives a cash compensation equivalent to the difference between the share price on the date of redemption and that on the date of issuing.
• ‘Full value’ phantom stock plans: in a ‘full value’ plan, the employee will receive cash compensation equivalent to the value of the underlying asset (common stock) on the date of redemption.

What is a Stock Award Agreement/Stock Option Agreement?

Sometimes, companies may choose to provide alternative equity rewards, such as restricted stock awards (RSA) or restricted stock units (RSU). These are treated differently for tax and are compensations granted to employees, making them eligible to earn shares upon fulfilling certain criteria or achieving milestones.

 

A stock award agreement is a contract signed between an employee and an employer outlining the terms and conditions of the employee’s stock award. This often includes information such as the number of shares that will be awarded, the vesting schedule and other conditions.

 

Stock option grants refer to how a company awards stock options. These documents detail various aspects of the award including:

• The type of stock options the employee will receive 
• Percentage or number of shares
• Strike price
• Vesting schedule
• Date of expiry 
• Reverse vesting clause

What are RSUs?

From the previous section, you may have read a brief mention of RSUs. RSUs are awards of shares given as a type of employee compensation after the recipient meets certain conditions. These are issued to employees through a vesting plan and distribution schedule, upon achieving milestones or upon the passage of a particular period. 

 

A point to note is that RSUs give employees interest in the company’s shares, but they do not have any tangible value until they become vested. When they do vest, they are marked at the Fair Market Value (FMV) and considered income. A portion of these shares would be withheld for taxes.

 

RSUs gained popularity among employers as an alternative to stock options after the mid-2000s accounting scandals involving giant businesses such as Enron and WorldCom. This resulted in the FASB (Financial Accounting Standards Board) issuing a notification requiring companies to book an accounting expense for the stock options they issued. RSUs then became increasingly preferred, as they were seen as the best alternative to continue attracting and retaining talent.

 

ESPPS – Employee Stock Purchase Plan

An ESPP is a purchase plan that lets you buy the company’s shares via a pre-determined schedule and salary deductions. In simple terms, if an employee A is offered ESPP from her company and she chooses to enrol, she can choose the sum that will be regularly deducted from her paycheck. These deductions will accumulate and will be used periodically to buy the company’s stock on her behalf. Upon purchase, holding, managing and selling the shares will lie with A. 

Some of the popular benefits of ESPP include:

• It is a way of saving and investing
• Purchasing at a discount
• Participation in the company’s success

The ESPP process works by the employee initially becoming eligible to participate and enrol in the plan. Following this, the company collects certain amounts from the employee’s paycheck and purchases stock on their behalf. Lastly, for the next purchase period, the employee may choose to increase or decrease their level of contributions.

 

Upon purchase, the shares are deposited into the employee’s account, which makes them eligible to sell them at any time unless agreed otherwise.

 

What Is The Need For Stock Options And Who Is It For?

Stock options are provided to attract prospective employees and retain existing ones. The incentive is that prospective employees can own the company’s stock at a pre-determined discounted rate compared to buying it from the open market.

 

Stock Option Vesting Schedules 

In simple terms, vesting refers to becoming eligible to earn something over time. Companies use this to incentivize parties to retain them with the company long-term.

 

An important concept associated with this is a ‘cliff,’ which refers to the period that must lapse before you are eligible to earn from the shares vested in you. 

 

How Are Stock Options Granted? 

Before granting stock options, a company takes into consideration a variety of factors such as:

• The number of options, 
• Exercise price, 
• Vesting schedule
• Grant date, and
• Post- Termination Exercise Period (PTEP)

Stock options are usually awarded via grants that provide all the details of the option plan. The plan is drafted by the company’s Board of Directors and entails the details of the employee’s rights.

 

How Do Stock Options Work Post-Termination?

When you leave the company, your stock options will stop vesting unless you agree otherwise. However, you will have the right to receive the possibilities already vested in you as of the date of leaving. This right will only continue until a certain period, a post-termination exercise period (PTEP). 

 

Why Should Employees, Founders Or Contractors Opt For Stock Options?

This compensation is preferred due to the benefits of stock options, including:

• Potential for financial gain
• Tax advantages
• Flexibility in deciding when to exercise the option
• Performance-based compensation for contractors in contingent vesting

Some notable stock option risks include market volatility, dilution and business failure.

 

Stock Option Tax Implications

The rules for taxing ESOP are assessed based on the company’s classification.

• Canadian Controlled Private Corporations (CCPCs) refer to privately owned firms whose shares are not publicly traded. Employees of CCPCs are not liable to pay tax until their shares are sold.
• Non-CCPCs – For firms like public corporations, employees become tax-liable for buying the shares.

Taxation based on the type of stock options:

1. NSO: IN NSOs, employees are liable to pay tax on the difference between the exercise price and the fair market value of the shares. This must be reported by the employees as a taxable benefit, and as a result, it would be taxed as regular income. They are also required to report capital gains/ losses on their tax returns after the sale of their shares or as deemed disposition upon death.
2. ISO: This provides some tax advantages to the employees. Here, upon exercising this option, employees have the right to sell the shares immediately. Unlike NSO, there is no requirement to report the difference between the exercise and current market prices to bundle it with regular income. Under this option, the employee must report capital gains/ losses on their tax returns only upon the sale of their shares or as a deemed disposition upon death.
3. Phantom stock: They are taxed as ordinary income as deferred compensation.

1. What percent of the company do my options represent?

An important question is what percentage of ownership you have over the company. For instance, if company A offers 100,000 options from 100 million outstanding shares, and B offers 10,000 options out of 1 million outstanding shares, the second one is more attractive. This shows that what matters is the percentage rather than the numbers upfront.

 

To ensure the percentage of ownership you will acquire, make sure that fully diluted shares outstanding, including common stock/ RSUs, preferred stock, options outstanding, unissued shares remaining in the options reserve, and warrants, are used to calculate the percentage.

 

2. What happens to my shares if I leave before my entire vesting period has been completed?

If you leave the company before the completion of your vesting period, usually your shares will return to your employer at no profit being earned by you.

 

3. How much will you pay for the stock when you exercise your option?

Buying shares through the ESOP means that you will still be paying for the stock when you exercise your option, yet you receive them at a bargained price, considering that you will pay a price lower than the current market price.

 

It may be noted that you are not mandated (unless agreed otherwise), to exercise all your options at once. For instance, consider an exercise cost of 10,000 shares at CAD 50,000. If you exercise only 5,000 possibilities, that will leave you with 5,000 options at CAD 25,000 (5000 x 5 CAD)

 

4. How many stock options should I offer to employees?

You may consider how many stock options you should offer your employees as an employer. The answer is that there is no straitjacket solution for this. It is entirely dependent on the stage of development of your company. The most practical time to hand out stock options would be during the seed stage or pre-series A round. An employer must also be wary of offering too much equity, as more stock options mean more dilution of your shares.

 

Contact Pacific Legal for expert guidance

As it becomes increasingly important for employers to introduce attractive stock options to summon talented personnel and retain them, employers and employees may face certain complexities when it comes to completely understanding ESOP’s concept or legal aspects. This entails seeking the aid and advice of corporate lawyers in Toronto who have expertise in this field. They will ensure that you get a favourable position and remain legally compliant. Contact Pacific Legal Professional Corporation, a Canadian law firm, for advice from experienced business lawyers in Toronto.

 

Conclusion

Stock options are powerful tools for attracting and retaining employees by allowing them to participate in the company’s growth. However, navigating the complexities of ESOP, tax, vesting schedule, or creating an employee stock purchase plan will require expert advice and guidance. Seeking the help of our firm’s experienced lawyers will ensure that both employers and employees are well-informed and legally compliant.