Setting up an employee stock option plan (ESOP)

When setting up an Employee Stock Option Plan (ESOP), a company must ensure the plan works for both the employers and the employees. Employees should clearly understand what entitlements come with share ownership (if any). The most impactful program will align the “rewards” of share ownership with employees who value those rewards.

Consider the following questions when establishing an ESOP:

  • How will the ESOP impact existing owners?
  • How will employees fund the purchase price when they exercise their stock options?
  • How will employees cash out (whether voluntary or involuntary)?
  • Which employees will be eligible to participate in the ESOP?
  • What vesting conditions should be set that entitle employees to exercise their options?
  • What is the strike price?
  • Have alternative incentive plans been considered?

Designing and tailoring an ESOP

We work with clients to first ensure an ESOP is the best solution and then assist with designing and implementing the plan. We often field calls from employers who have implemented templated ESOPs and they want assistance with fixing them. This is more expensive, and not always feasible, compared to setting up an ESOP the right way from the start.

ESOP-eligible employees should receive an information package explaining the plan. In practice, ESOPs can be set up in different ways. While an employer may refer to a plan as an ESOP, the term can mean different things to different people.

Budgeting for the plan

Employers should consider how share ownership could look five to ten years into the future with the ESOP in place. Existing owners and shareholders (prior to introducing an ESOP) will want to understand how an ESOP will affect their ownership interest. Generally, 10 to 20 per cent of the 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 to find the ESOP rewarding.

Employees must be able to fund the purchase price when they exercise their stock options. Employers should consider how to ensure employees can fund the purchase price. Some considerations:

  • Is another incentive program required in tandem with an ESOP to enable employees to purchase the shares?
  • Should the employer implement a loan program for employees?
  • How should the strike price be set?
  • What are the income tax implications for employees that join the ESOP and how could tax impact their personal cash flow?
  • How will employees cash out (whether voluntary or involuntary)?

Employee eligibility

Each company must determine which of its employees are eligible for the ESOP. It might be worthwhile to offer different ESOPs to different groups of employees because what works for one (e.g., senior executives) might not work for another (e.g., administrative staff). If an employer offers the same ESOP to all employees, the plan will not achieve its objectives if one group never exercises its options (we have seen that happen).

Whether all employees are eligible depends on the type of company, industry practices and competitors’ plans. There is also a question of whether the ESOP will act as a mechanism to top up otherwise underpaid employees or as an extra incentive to already well-paid employees. Many technology companies offer ESOPs to all employees, so potential employees at all levels expect them.

Setting up vesting conditions

Vesting periods are typically three to five years with a percentage of the stock options vesting each year. Cliff vesting (i.e., allowing the shares to vest immediately) may want to be considered to attract senior executives to the company.

Alternatively, vesting could occur when the company or employee meets certain targets, such as revenue growth or other relevant key performance indicators.

Determining the stock’s strike price

Fundamentally, an ESOP is a right that an employer grants to employees to purchase the company’s shares at a predetermined fixed price in the future. Therefore, employees have an incentive to exercise their stock options when the shares’ fair market value is greater than the strike price at the time they have vested.

Employers must decide whether or not they want employees to pay for shares that can be purchased through an ESOP. This decision links to the employer determining the objectives for the ESOP and ensuring the plan is set up to align with those objectives. For example, will the employer reward past performance or future performance? Does the employer want employees to pay for shares to have skin in the game? Will employees be able to afford the share purchase price?

The strike price will have income tax implications for the employees. 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 strike price as set out in the Income Tax Act (Canada). Employees can receive a tax deferral 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% of the value of the taxable benefit when certain conditions are met; the strike price may impact employees’ ability to obtain this 50% deduction.

Other incentive plans to offer that complement an ESOP

Other incentive plans can be considered, which range from providing cash payouts to share ownership. For example, employers can implement bonus plans, employee profit sharing plans, phantom stock plans, employee share ownership trusts and straight share sales to employees. All plans must be well designed to work for both employers and employees.

Canadian Federal Budgets 2021 and 2022 both included commentary that the government is looking to introduce a new planning option: an employee ownership trust. I am excited about this new plan and hope that it will make it easier to transfer company ownership to employees.

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