What to know if you’re creating an employee stock option plan
What to know if you’re creating an employee stock option plan
An employee stock option plan is mutually beneficial to you and your employees, but it must be properly designed and implemented to help both parties achieve their goals.
An employee stock option plan (ESOP) is a right that a company offers its employees to purchase shares of the company in the future at a predetermined fixed price. Employees will benefit from exercising their stock options because they have the opportunity to purchase the stock at the historic price that is less than the current price.
When establishing an ESOP, you must ask yourself the following questions and ensure that the corresponding answers align with your objectives.
How will the ESOP impact existing owners?
You must consider how the ESOP will impact the existing shareholders of your company prior to implementing an ESOP. Generally, 10 to 20 percent of a company’s value is offered to employees; there must be a balance between employers giving up ownership versus the ownership pool being sufficient for employees. You should also consider how ownership value may look five to 10 years into the future. This will ensure you and your employees find the plan rewarding for the long-term.
Which employees are eligible for the ESOP?
You need to determine eligibility criteria that allow an employee to join the ESOP. There is no one-size-fit-all guideline for determining which employees will be eligible for the ESOP. You may want to offer tailored ESOP plans for different groups of employees because what works for senior executives may not work for other employees.
Your compensation strategy should tie into the ESOP. You should be aware of whether the ESOP will act as a mechanism to fairly compensate otherwise underpaid employees or will act as an extra incentive to already well-paid employees.
What vesting conditions should be set that entitle employees to exercise their options?
Vesting conditions determine when an employee can exercise their stock option and can be based on a set timeline, for example, three to five years from the date the options were granted to the employees, with a percentage of the stock options vesting each year. The set period must not be too long or short; setting it too long can make it out of reach for employees, while having it too short might allow them to exercise their option and leave your company prematurely. Alternatively, vesting conditions could be based on the employee meeting certain targets such as revenue growth or other key performance indicators.
What is the exercise price?
The exercise price must be set for the shares your employees can purchase through the ESOP. You must decide whether and how much you want your employees to pay for the shares that they can purchase through the ESOP.
You need to consider, for example, setting the exercise price low enough that employees can afford it and can help the company reach the target value underlying the exercise price. But you also want the exercise price to be high enough to motivate your employees to help grow the company. You also should consider whether the ESOP program is meant to reward past or future performance.
The ESOP will have income tax consequences to your employees, and the exercise price will impact the amount of the income tax liability. Generally, employees will have a taxable benefit equal to the difference between the fair market value of the shares at the time of exercise and the exercise price as set out in the Income Tax Act. The taxable benefit can be deferred for your employees until the stock options are either exercised (if not a Canadian-controlled private company) or sold (if a Canadian-controlled private company). Employees may also receive a tax deduction equal to 50 percent of the value of the taxable benefit when certain conditions are met; the exercise price may impact the ability to obtain this deduction.
How will employees fund the purchase price when they exercise their stock options?
You must consider how employees will fund the share purchase when they exercise their stock options. Consideration should be made to offering another incentive program to your employees, so they have cash to purchase the shares. Alternatively, you may want to consider setting up a loan program for employees.
Your employees will want to know how they monetize their share value, whether voluntary or involuntary, for example whether, how and when they can sell their shares.
Have you considered alternative incentive plans?
You can compliment your company’s ESOP with other incentive plans that provide cash or share ownership to your employees. For example, you can implement bonus plans, employee profit sharing plans, phantom stock plans, employee share ownership trusts, and direct share purchase and sale programs to employees. The federal government announced in both budget 2021 and 2022 it was looking to introduce a new incentive plan, employee ownership trusts.
Whatever plan you select must be delicately designed and implemented to benefit both you and your employees.
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