The following bulletin provides an overview of a number of equity-based compensation mechanisms including stock options, restricted share units and deferred share units. Equity-based compensation plans are subject to complex tax and securities law considerations. Businesses should consult with a lawyer before implementing equity-based incentives.
1) Stock Options
What is a Stock Option?
A stock option provides an individual, such as an employee, insider, director, or other service provider (the “Recipient“), the right to purchase a share of the company granting the stock option, at a predetermined price in the future (the “Exercise Price“) before the option’s expiration date (discussed further below).
If share price appreciation occurs, a Recipient can profit by “exercising” their options, meaning that the Recipient will use their right to purchase company shares at the Exercise Price and sell the shares at some point in the future. The Recipient’s “profit” is equivalent to the difference between the Exercise Price and the fair market value (“FMV“) of the shares when sold.
What is a Stock Option Plan?
A stock option plan governs the issuance of options from a pool of stock options by the granting company.
Issuing stock options allows businesses of all sizes — from start-ups to established public companies — to attract, motivate, and retain employees.
In the private company/start-up context, companies can offer stock options as a method of supplementing employees’ compensation to attract top talent.
In the public company context, stock options are considered a strong compensation incentive as they provide the Recipient with the possibility of owning shares in the granting company at a discounted rate compared to buying shares directly from the market.
A carefully planned stock option plan can align employees’ motivations with shareholder expectations as the employee is rewarded based on company growth and stock price appreciation.
Vesting Period
Stock options act as a powerful incentive if they are aligned with the medium or long-term goals of the granting company.
To align incentives between Recipients and the granting company, stock options usually contain vesting periods, which refer to the periods of time between the stock options’ grant date and the date the Recipient earns the stock options. A Recipient cannot exercise an option until it has vested.
Traditionally, vesting periods are created in reference to the passage of time, the achievement of a specific goal, or both the passage of time and the achievement of a goal.
A company’s vesting period should be strategically aligned with the reason for issuing stock options. If the vesting period is too short, the granting company may be giving away equity without achieving its strategic goals. Conversely, if the vesting period is too long, the Recipient may view the stock options as unachievable, creating a disconnect with the company’s strategic goals.
Size of Option Pool and Participating Share Classes
Typically, a company will reserve approximately ten percent of its total shares outstanding, for the purposes of a stock option plan (the “Option Pool“). It is important to consider how many shares will be reserved for issuance. Too many stock options being exercised in a short time will have a diluting effect on existing investors.
A company issuing stock options will also have to decide what type of shares will be eligible for issuance (participating shares can be voting or non-voting). If a company has multiple classes of shares, the company must determine whether options should have their own class of shares and whether the class of shares should have similar rights to the company’s other classes of shares.
2) Restricted Share Units
What is a Restricted Share Unit?
A restricted share unit (“RSU“) represents a contingent right to receive shares, or cash compensation equal to the value of shares, in the granting company.
Unlike stock options, RSUs typically do not have an Exercise Price, as they are settled into shares in accordance with time-based and continued employment vesting conditions.
The holder of an RSU is not considered to be the beneficial owner of the underlying shares until the RSUs have vested and shares have been issued in settlement of the RSUs (the “Settlement Date“). As such, the employee would not be entitled to voting, dividend or other shareholder rights until the Settlement Date.
3) Deferred Share Units
What is a Deferred Share Unit?
A deferred share unit (“DSU“) is a particular form of RSU which meets prescribed conditions under the Income Tax Act (Canada), as further described below.
DSUs represent a right to receive payment (via shares purchased on the open market or cash) based on the FMV of the shares of the granting company.
DSUs are only realized after an employee’s death, retirement or loss of office or employment (the “Triggering Event“). As a result, DSUs are typically granted to directors and senior executives; employees usually prefer an earlier realization, such as through RSUs.
Specifically, to qualify as a DSU, a DSU plan must meet the following requirements of Income Tax Regulation 6801(d):
- There must be an agreement between the employee and employer pursuant to which the employee becomes entitled to DSUs, attributable to their duties of an office or employment;
- all amounts to be received under the arrangement after the occurrence of the Triggering Event must be received no later than the end of the first calendar year (i.e., December 31) commencing after the Triggering Event; and
- the amount paid to the employee under the arrangement must depend on the FMV of the shares of the employer, determined at a time within the period that commences one year before the Triggering Event and ends at the time the amount is received.
Conclusion
Stock options, restricted share units, and deferred share units can serve as powerful tools to attract, motivate, and retain individuals that are vital to a company’s success. However, they must be considered in light of tax considerations which will be further discussed in our upcoming Employee Incentives Part II bulletin.
The above information only provides a brief summary of certain types of equity-based compensation. Members of the Securities and Business Law Groups at Fogler, Rubinoff LLP would be pleased to discuss how equity-based compensation plans may be suitable for your business.
This publication is intended for general information purposes only and should not be relied upon as legal advice.
