An Employee Stock Option Plan (ESOP) allows employees to own a piece of the company in the future and benefit from its growth. Startups use ESOPs to attract and retain talented employees and manage the vesting of options over time. This guide covers the key aspects of setting up and maintaining Employee Stock Option Plans for startups in Canada.
Why Create an Employee Stock Option Plan?
Most startups have big plans to grow their workforce and scale operations. And they will need great employees to get there. Options are a huge incentive for new employees to join a startup rather than a large established company. Knowing that early-stage startups probably can’t match the salaries paid by industry leaders, options provide a lucrative form of compensation that will grow in value over time.
How do Employee Stock Options work?
Instead of buying shares in the future and paying the future price (after the company has become more valuable), options allow employees to purchase shares in the future at their present value. Assuming the company grows over time, options will allow the employee to purchase shares at a significantly reduced price to future shareholders.
As an example, Employee A is granted 10,000 options. The current price of each share is $0.01. In a few years, the company’s price per share has grown to $1. When Employee A exercises the options (which is the technical term for purchasing shares based on options), they will pay $0.01 per share for 10,000 shares, for a total of $100. However, the true value of the 10,000 shares is now $10,000. So Employee A has purchased shares for $100 that are worth $10,000, meaning Employee A has profited $9,900 in addition to their regular salary.
What is an Employee Stock Option Plan (ESOP)?
An Employee Stock Option Plan outlines the policies and rules for how employees can purchase shares in the company at a favourable price sometime in the future. An option is simply a contract between the company and an employee saying that on a certain date in the future the employee will be able to purchase shares in the company at a set price. However, to ensure options are distributed fairly and on terms that make sense for all shareholders in the business, the ESOP contains all the high-level terms for offering options.
The ESOP will have implications for the company’s long-term ownership structure, but no money needs to be exchanged at the time the ESOP is created. The ESOP covers the timelines and circumstances where share purchases can be made in the future.
In this Guide, we cover all the major elements within an Employee Stock Option Plan, including the Option Pool, Option Award Agreement, Exercise Price (aka the “Strike Price”), Expiry Date, and Vesting Provisions.
What is an Option Pool?
The Option Pool holds a portion of the company's shares that can be awarded as options to employees in the future. The ESOP will set out both the number of shares in the Option Pool and the class of shares it will contain. An Option Pool almost always consists of non-voting shares, so employees will be able to benefit from the growth of the company without having to vote on management issues.
Careful consideration should be given to the size of the Option Pool. Founders will typically try to establish a conservatively sized pool to avoid diluting their ownership (for example, 10% of the total number of issued shares). Investors, employees and other stakeholders might push for a larger Option Pool (20% or higher) to ensure there will always be plenty of options available.
Shares in the Option Pool can't be used for any other purpose so long as the Option Pool exists. The Option Pool will appear on the company's cap table as if these shares no longer belong to the company's founders. However, in reality, these shares are not owned by anyone and don’t directly affect the founder’s ownership stake until they are awarded.
Changing the size of the Option Pool is a complicated process and is best avoided if possible. To change the Option Pool, the ESOP itself will need to be replaced. So it is best to have a realistic perspective on the size of the Option Pool at the time the ESOP is created.
What is an Option Award Agreement?
The Option Award Agreement is the actual contract between the company and the employee receiving options. While the ESOP is a policy document for the company, the Option Award Agreement is specific to each employee's options. The Option Award Agreement will contain things like the number of options being awarded to the employee and the Exercise Price the employee will eventually need to pay to receive shares (see more on the Exercise Price/Strike Price below).
The ESOP should contain a generic sample of the Option Award Agreement, so there is a standard form that all agreements will take. But the Option Award Agreement will need to be customized each time one is signed by an employee.
What is the Option Exercise Price? (Strike Price)
The Option Exercise Price (also called a "Strike Price") is the price the employee will pay to purchase shares in the future. The price must be set in the Option Award Agreement, even though it won't be paid at that time.
The Exercise Price can be a tricky issue. Employees will get the most benefit from a low Exercise Price. But the Exercise Price can’t be unreasonably low. It must reflect the fair market value of the shares on the date options were awarded (not when the shares are actually purchased).
This requires a realistic assessment of the current fair market value of a company’s shares each time options are awarded. On Founded, we have built a helpful tool to give a rough approximation of a reasonable Exercise Price when awarding options.
Remember that options aren’t free. They represent the current value of the shares and allow employees to benefit from the company’s growth. Entering an unrealistically low number could have negative tax consequences for both the company and the employee, while a price that’s too high will decrease the benefits for the employee.
What is the Option Expiry Date?
Given that the overall number of options is limited to what is in the Option Pool, options come with definitive timelines for expiration. This ensures if an employee doesn't want to convert the options into shares by purchasing at the Exercise Price, that the company can re-issue the options to another employee.
The most common situation where expiration dates are important happens when an employee leaves the company (either through resignation or termination). The departing employee will have a certain number of days to exercise the options and purchase shares. If the employee does not act within the set timeline, the options will expire and get returned to the Option Pool. These timelines are strict and need to be observed by the employee in order to avoid losing out on the options. A reasonably common expiry period is 90 days, although it will depend on each particular company.
The other common expiration timelines is when an employee's options have fully vested (read more on vesting below). In this case, the employee needs to decide whether to exercise the options and purchase shares. If the options are not exercised after fully vesting, they will be returned to the Option Pool.
What are Vesting Provisions for Options?
Options are intended to encourage employees to make a long-term commitment to growing the company. So it would be counterproductive if employees received all of their options at one time. Vesting provisions allow options to be awarded incrementally with the time spent working for the company. The longer the employee works at the company, the more options they will receive.
Even with gradual vesting, there is usually a minimum amount of time required before any options are awarded. This is called the “cliff period”. It is quite common for a company to set a one-year cliff period, so if the employee resigns or is terminated less than one year after becoming an employee, they will not actually receive any options.
On Founded, employees can track their options over time, making it easy to see how many options have vested and how many more will vest over time.
How do Taxes Work with an Employee Stock Option Plan?
Taxes can be a complicated subject that will differ based on the financial circumstances of each company and each employee. However, options are popular in Canada largely because they’re simple for tax reasons. In short, options let both the employee and the company defer tax implications until a later date.
If an employee received shares in addition to a salary as compensation for their work (rather than options), those shares would need to be added to the employee’s income each year to determine how much tax would be owing. Employers typically only deduct taxes arising from regular salaries or wages, so the value of the shares would result in an increased tax bill for the employee.
When it comes to taxes, options are a simpler alternative than directly giving shares to employees. Since an option is just an agreement related to the future opportunity to purchase shares, the tax implications don’t arise immediately. Even when the employee actually exercises the options and purchases shares from the company, the tax implications are usually quite minimal. The eventual tax consequences for the employee are deferred until those shares are actually sold and the employee earns a return on the shares.
Who can Receive Stock Options?
While this guide has focussed on employees, they are not the only ones that can receive options. Anyone who contributes to the company over time is entitled to participate in the Employee Stock Option Plan, even if they are not technically employees. This can include the company's directors, consultants and contractors. In any case, options should be used to secure long-term commitment from individuals that will help the company grow.