Ask a Lawyer: How should I design my employee stock option plan (ESOP)?

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Welcome to a regular series powered by Blakes to help startups and entrepreneurs. In each article, a Blakes legal expert tackles common scenarios facing founders today (disclaimer below).

Scenario: you have recently founded a company and may have already raised seed capital. You need to assemble a winning team on a budget, and are interested in putting a stock option plan in place.

A stock option is the right to purchase a share of the company at a predetermined price. Stock options can be a great and tax-efficient way to incentivize your employees, with the added benefit of having no impact on cash flow. The most important features of an employee stock option plan (ESOP) are: (1) how vesting works, (2) size of the plan, (3) what happens when someone leaves the company, (4) what happens to the options when you want to sell the company, and (5) strike price and taxation. It’s critical to have proper legal documentation in place when establishing a stock option plan.

Vesting

Once a stock option is vested and any additional conditions relating to exercise have been met, the employee can exercise it to buy a share of the company. Vesting conditions are contractual, and there is a lot of flexibility when you set them up. The most common vesting conditions we see in the Canadian marketplace are based on continued service over a period of time, and in the tech world being over four years, 25 percent at the end of year one, then equal parts per month over the ensuing three years.

However, consider being a bit more creative with vesting conditions and don’t feel you need to accept the norm. Rather than being based on time, an effective way to incentivize people to achieve your business aims is to base vesting on performance goals relevant for the employee, such as achievement of a certain level of sales, completion of a big development project, etc. This is particularly useful for more senior employees who have greater control over the direction of the business, but can be useful broadly as well depending on the circumstances. Vesting can also be based on a combination of time and performance. Extra care should be taken with designing, documenting, and communicating performance vesting as it can be a little trickier to implement properly. However, done right, performance vesting can be a very good motivating too.

Size of the pool

If you don’t take it seriously or if you do it improperly, it could have serious and costly consequences to your venture.
 

Option pools normally range between 10 percent and 25 percent of the company’s fully diluted equity (which basically means the number of shares of the company assuming all options, convertible debt and preferred shares are converted to common shares), with 10 percent and 20 percent being the most common range that we see for a startup. If options will only be used to incentivize a few people, the pool size can be much smaller, but it’s really context specific. What works for one venture might not make a lot of sense for another.

Finally, when deciding on size, make sure to keep in mind that every option you issue will dilute your founder equity. You should strive to be fair to your team and to use options to maximize team alignment with venture success, but also be sensible in how much you give away. Also, just because you have a pool available, doesn’t mean you should issue it fully right away. You should make sure to leave space for new hires.

What happens when someone leaves

It’s critical that employee stock option plans address what happens when an option holder leaves the company (whether voluntary or involuntary). In most circumstances, the plan should provide for unvested options to terminate immediately and give a relatively short period for an employee to exercise vested options after departure, after which vested options will automatically expire.

Both vested and unvested options should automatically cancel upon a termination for cause. The reason for this is that you want your option pool to be available to incentivize the people working for the business, not those that have left, and you want to keep your cap table as clean as possible.

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Liquidity events

Option holders will not be subject to your shareholder agreement until they exercise, so you need to have provisions in the plan to deal with the options upon a company sale event or IPO.

The more flexibility, the better, but essentially you should have the ability to deal with the options in the company’s sole discretion upon a sale event or to require the option holders to participate in the transaction (obviously in a way that is fair to option holders), like a drag along right in a shareholders agreement. Most buyers will want to get 100 percent of the fully diluted shares in a sale transaction, including the options. If you don’t have the power to take out all of the options with certainty on a sale event, in particular if you have some unhappy option holders, you will have a significant problem to navigate.

Strike price

The strike price is the price that an option holder must pay to exercise the option for one common share. For tax and commercial reasons, in most circumstances, it is often important that the strike price be no less than the fair market value of the shares at the time the option is granted. For this reason, it is often better to issue options earlier before significant value is built in the company, i.e. while you can still reasonably issue options with a very low strike price without running into tax problems.

If your venture is a “Canadian controlled private corporation” (CCPC), then there can be even more benefits.

If you’ve already raised third party financing, the price paid for shares in the round will be a good starting point for establishing the fair market value of your venture at that time. In certain circumstances, it may be reasonable to apply a minority discount to the option exercise price or a discount to the price paid for preferred shares in the round (preferred shares may be worth more than the common shares in most circumstances). Professional valuators are also available to assist with these questions.

Tax

Stock options can have some big tax advantages compared with other forms of employee compensation. The biggest advantage is that option income will effectively be subject to only half as much tax as ordinary income (i.e., treated similar to capital gains) provided that the options are not “in-the-money” when issued and certain other technical conditions are met. The technical conditions can usually be met with proper planning, but it is important to get tax advice to ensure the plan and grants are set up correctly.

If your venture is a “Canadian controlled private corporation” (CCPC), then there can be even more benefits, including allowing your employees to defer tax until they sell the shares (instead of being taxed at the time of exercising the option), and obtaining the “half tax” treatment even with a discounted strike price (provided the shares are held for 2 year after exercise).

However, be aware that not everyone can get the same tax benefits from stock options. Employees who are controlling shareholders, or otherwise “non-arm’s length” to the company, would generally not get the advantages described above, nor would independent contractors. Also, the company will generally not be able to deduct the cost of using stock options to compensate employees.

Final thoughts

While all of this may seem a bit daunting, setting up an ESOP for a venture stage company can be achieved quickly and painlessly, and with relatively minimal legal cost. That being said, if you don’t take it seriously or if you do it improperly, it could have serious and costly consequences to your venture. You should make sure to engage legal counsel that is experienced in the venture space.

One final thought: your option plan will be a key part of attracting talent and aligning their interest with the interest of the venture. The one thing we think many founders often miss out in their ESOP is exploring the possibilities in designing tailored vesting conditions that are tied to performance rather than simply time spent with the company. Designing good performance based vesting conditions will take more effort to ensure it is done correctly, but it may be well worth it given that performance based incentives can be a powerful way to motivate your team to achieve key business milestones.

This piece is intended for informational purposes only and does not constitute legal advice or an opinion on any issue. We would be pleased to provide additional details or advice about specific situations if desired.

Photo via Burst.


About the Authors

Justin DrakeJustin Drake is a corporate lawyer with a practice that focuses on mergers and acquisitions, joint ventures, venture capital financing and general corporate and commercial matters. He has extensive experience working with startups. Recent venture technology transactions he was worked on include TD’s acquisition of Layer 6, McCain’s strategic investment in TruLeaf and Khosla Ventures’ series A investment in Deep Genomics.

Ian Caines

Ian Caines is a tax lawyer practicing in the areas of domestic and international Canadian income tax law. Ian’s work has included mergers and acquisitions, reorganizations, financings, and tax disputes matters. Ian is also interested in the implications of technology for law and has worked with a technology start-up business developing new tools for legal practice. Ian’s favourite programming language is Python.

Lindsay McLeod

Lindsay McLeod is a pensions & benefits lawyer with a practice that focuses on all aspects of pension, employee benefit and executive compensation plans. Lindsay advises clients on regulatory compliance as well as the taxation, design, administration, governance and termination of these arrangements.

Blakes

Blakes

Blakes is a full service Canadian law firm, and its Nitro program is designed to provide access to top-tier legal services for qualified emerging technology companies. For more information about Blakes or Nitro, visit blakes.com or blakesnitro.com.