Today we’re going to talk about employee stock option plans.
Difference between options & shares
Before we get into that, I’m just going to break down what the difference is between options and shares. So shares quite simply they represent an ownership stake in a company. So say a company has 100 shares that means there are 100 ownership stakes in that company and each of those shares is going to be worth 1% of the company.
So whereas an option, an option is a right to purchase one of those shares in the company. It’s not an obligation to purchase them when you receive options, you’re holding that ability to purchase shares in the company at a later date and generally how options work is that they have a strike price; a strike price or also called an exercise price and that price is going to be, hopefully below what the market value of the shares is.
So let’s take an example, say I am becoming an employee of apple and apples’ shares are worth $200 – $200 each, and my options entitle me to purchase shares in the company for $1. In this example, the gap between the exercise price and the actual price of the shares is $199.
So it’s a really good deal for me.
So this means that if I choose to exercise those options, I can convert those options into shares and I’m going to get a huge benefit as a result of that, a benefit is taxable by the way but more on that later. Coming back to employee stock option plans.
what they are, why they’re useful and setting up an employee stock option plan
So this video we’re going to cover off what they are, why they’re useful, and what are the main mechanics in setting up an employee stock option plan.
So first of all, why they’re useful in that they allow your company to align the incentives of your employees with the owners. So you’re essentially enabling your employees to become a quasi owner of the company by holding those options and then eventually to become a full-fledged owner when they convert those options into shares.
So this encourages your employees to adopt more of an owner’s mindset, encourages them to think on the long term and to just generally respect and build out the company as if it were their own because it is. Employee stock option plans also building loyalty for your key employees by locking them into an agreement where they get some of the options in year 1 some in year 2, some in year 3, some in year 4 so this is commonly known as a cliff and a vesting period so the cliff idea is that they don’t receive any shares at all until the cliff period has expired. So typically this is one year.
So usually an employee wouldn’t receive any options the first year of working for the company and then afterwards he’s going to receive, he or she is going to receive 25% of the options every year. So 25% year 2, 25% year 3, 25% year 4, 25%5 and so on.
So by the end of those five years, then that person will have received all of those options and can exercise those options at any point that they choose before the expiry date of the options.
So when is a good time for a company to use an employee stock option plan?
Generally, an employee stock option plan is useful after the first round of financing has been done. But before a startup has begun doing a major round of hiring. So an employee stock option plan allows you to inject a little bit of structure to how – how much equity you are prepared to offer to each key employee and generally you should be approaching that subject with a good deal of thoughtfulness.
So you’re not just putting the company in a position where it is doling out larger chunks of equity than you had originally intended and then you wind up with a company where too much of the equity in the company has been diluted.
So how much of the company should you put into an employee stock option plan?
Well, this depends on a lot of different factors. It could be anywhere from 5% of the company to 20% or even25% of the company, but it really depends on a lot of different variables; including what type of industry you’re in, how important the key employees are to your company.
So for example, a company that where the founders are extremely important to the business and the people who work within the company are primarily filling administrative or back-end roles. Those employees are not going to receive big-equity chunks. Whereas in another type of company where the founders are more taking a backseat, they’re a bit more hands-off, they are just the guys and gals who are starting out the company and getting the wheels turning but they’re not necessarily the ones who are doing a lot of the execution nor the management of the company, they’re a little bit more hands-off, that type of company.
It’s going to be on the higher end of the scale and you might see the company offers as much as 25% of the company to its key employees. As a general rule of thumb, the first 10 employees of a start-up can expect to receive 10% of the equity of the company the next ten, 5% and the next 50, 5% after that.
So the first in, tend to get the largest chunks because those are the most important roles. Those are the most unique and niche employees and likely the most skilled employees that you have. So tax consequences of creating an employee stock option plan. So if your company is a Canadian controlled private corporation or a CCPC, which most Canadian private companies are then there are no tax consequences for setting up an employee stock option plan or issuing those options and there are no tax consequences for the employee who is in receipt of those options.
The employees only going to be taxed at the point where they exercise the options so they received the options for – to exercise the options at a dollar and but then the actual market price of the shares is $10, then they’re going to realize a $9 taxable benefits at the point in time when they exercise those options. Keep in mind that there is also a deferral mechanism that is built into our tax code.
So they can actually defer the recognition of that gain to the point in time when they sell the shares in the company. So just keep that in mind for your key employees.
So finally, a few current scenarios that people are always thinking about and should be thinking about when you’re creating an ESOP is, so what happens if the company is bought?
So if a company is acquired by another entity then generally what happens is the options will immediately vest.So what that means is the thing earlier that I mentioned about the cliff period and the vesting period and the vesting happening over anywhere from 1 to 5 years, that would immediately accelerate and all of those options would become immediately vested.
So the employee who holds those options could exercise them at that point. The second scenario is well what happens if the company fails if the company sputters out and doesn’t go anywhere?
Well in that case in the options are worthless.
So what happens if an employee of the company who’s holding these options is fired or decides to quit and move on?
Well generally, any options that haven’t vested already, they would not be able to – those options would not vest in the future and so that means that they would essentially be forfeiting their ability to use those options and to convert them into shares of the company.
So if you have any other specific questions about employee stock option plans, if you are considering creating one in you’re wondering how much of your company you should be giving out to certain key employees or if you’re an employee and you are receiving an employee stock option plan and your wondering if you could negotiate, if you can potentially get a little bit more and like just what is reasonable?
These are all really good questions to ask your legal advisor, all really good questions to bring up withsomebody who has seen a number of employee stock option plans.
So feel free to reach out to me directly, or you can leave your comments below and I’ll be happy to get back to you!
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