Spotlight On: Issuing and Receiving Options
October 25, 2022
Stock options can be a great way to incentivize and reward your team. Here’s what to keep in mind when it comes to issuing them.
Options can help companies attract and retain employees, consultants, officers and directors in a tax-efficient manner while preserving capital. Here’s what to keep in mind if you are considering issuing them.
What are options?
An option is a right to acquire, or receive the benefit from, something else. A stock option is a right to acquire stock, or shares, of a company.
Stock options typically allow the holder to purchase shares of the company for a certain period of time into the future, at an “exercise price” (or “strike price”) set now, even if the fair value of those shares increases later on.
Options may either be immediately exercisable, or may contain conditions which must be met in order for them to “vest”, or become exercisable. A common condition is that the optionholder must continue to serve with the company for a certain period of time.
Begin with tax advice
Get tax advice before having any discussions about options, as issuing (and receiving) options can have tax consequences. For example, they might constitute “income” or a “taxable benefit” to the recipient. There are also technical requirements for taking advantage of beneficial tax treatment of options. Check with your tax advisor, as the rules have been subject to recent changes.
A company may also consider whether its capital structure requires any changes before implementing an option program. Some companies may wish to put a shareholders’ agreement or voting trust agreement in place (see “Shareholders’ Agreements and Voting Trust Agreements” below), or may create a class of non-voting shares for which the options are exercisable.
Alternatives to options
There are a number of alternatives to options, such as restricted stock units and deferred share compensation, which you can consider if your tax advisor thinks appropriate. Other alternatives include:
- Cash. Cash may be simpler for a company to issue, and does not give the recipient the potential to become a shareholder of the company. However, the cost of capital for a growing business may be significant, and a company may wish to preserve cash for other uses.
- Shares. You may prefer to issue shares directly to your recipient. Corporate statutes require that shares can only be issued in respect of past services performed, so shares cannot be issued in anticipation of future work (although a company may promise to pay someone in shares once the work is done). Shares may also be taxed as income to the recipient, so thoughtful tax advice for both parties should be sought before any issuance.
- Reverse vesting. If you issue shares, a reverse vesting agreement allows the corporation to repurchase them later on if certain conditions are not met. Using reverse vesting can help a person feel fully invested on day one while mitigating some risks if things don’t work out, but requires your recipient to pay for their shares up front – which may be a challenge if your company has more than nominal value. See our Spotlight blog for more information about reverse vesting.
To whom can you grant options?
Options are commonly granted to directors, executive officers, employees, and “consultants” of a company. Section 2.24 of National Instrument 45-106 (“NI 45-106”) provides a specific prospectus exemption for these groups, subject to certain conditions.
To be considered a “consultant”, a person must provide services to the corporation or a related entity pursuant to a written agreement, and must spend a significant amount of time and attention on the business and affairs of the corporation or a related entity.
Options may also be granted to a variety of other groups, depending on other types of prospectus exemptions which are available.
Shareholders’ Agreements and Voting Trust Agreements
If your corporation has a shareholders’ agreement in place, you should have a condition to the exercise of the options that the optionholder become a party to that agreement. See our Spotlight blog about shareholders’ agreements for more information.
A voting trust agreement can also be a useful tool in conjunction with an option plan. A voting trust agreement assigns to another person (the voting trustee) the voting power over shares of shareholders subject to the agreement. Those shareholders retain all of the other rights and benefits associated with the shares, including the right to receive dividends, but the company can rely on the voting trustee to complete written shareholder resolutions and vote at meetings on the shareholders’ behalf.
How options are granted: option plans vs standalone agreements
Options can be granted by standalone option agreements or pursuant to an option plan.
An option plan can help a company issue various grants of options efficiently over time. A plan typically contains many of the terms and conditions for how the options are granted, how they may be exercised, and how they terminate.
If an option plan is in place, at the time of each option grant, the company and the recipient sign a simple agreement that incorporates the terms of the option plan and sets out any details that are specific to the options being granted (such as the number of options, exercise price, and any vesting conditions).
For a private company, an option plan can generally be adopted by a simple resolution of the board of directors (although if a shareholders’ agreement is in place, it should be reviewed together with any other relevant documents and policies for any additional requirements – see Shareholders’ Agreements and Voting Trust Agreements above).
Whichever method you choose, consider any related documents and contracts, and how they may affect the terms set out in your option agreement. In a 2020 decision, the Ontario Court of Appeal found that the termination provisions of a standalone option agreement took precedence over those in an option plan that was subsequently implemented by the company, even though the agreement incorporated the terms of the plan.
Having the option grant discussion
It is good practice to ensure that option recipients review and understand the terms of their option agreement, including any termination provisions, from the outset. Provide them with a copy of the option plan and any other relevant materials. It’s good practice to have your key points ready, including the number of options and the vesting conditions, and to document the conversation afterward.
Recipients should be encouraged to review any option documentation with their lawyers and tax advisors. Even a cursory review by a recipient can make it more likely that the agreement terms are enforced as intended. For example, in a recent decision, Battiston v. Microsoft Canada Inc., the Ontario Court of Appeal upheld the cancellation of stock options upon an employee’s termination because he clicked a box in an e-mail confirming he read the stock award agreement. (The Supreme Court of Canada recently dismissed the employee’s leave to appeal.)
Public company requirements
Canadian stock exchanges have various rules that address security-based compensation arrangements. For example, the issuing company may be required to obtain approval of an option plan from its shareholders and/or the exchange.
Stock exchanges may also place restrictions on the number of shares available to be granted under a plan, the minimum exercise price that can be used, and the length of time that certain recipients must hold their shares before they can be traded on the public markets.
- Get comfortable with your tax and corporate planning before discussing the issuance of any options (or any other securities) with potential recipients. Setting everyone’s expectations from the start can help avoid misunderstandings later on (see our blog on forgotten shareholders for some examples).
- Tax advice is an important initial step. Here’s a great infographic from Ali Spinner, a tax partner at Crowe Soberman LLP.
- Ensure your corporation has all the authorizations it requires to issue options under its articles, any shareholders’ agreement in place, and any other relevant documents.
- A company’s board of directors should document its approval in advance of an option plan and any option grants it wishes to make.
- Plan and document the options conversation with recipients as much as possible. Be clear about vesting and exercise conditions. Give the recipient copies of key documents and encourage them to review them with their legal and tax advisors.
- In an option agreement, keep vesting and termination provisions clear and unambiguous.
- Keep track of key dates: when your options were granted, when they vest, and when they expire. Keep your minute book updated accordingly.
- If you are a publicly listed company, check any additional requirements of your stock exchange.
This blog post is not legal or financial advice. It is a blog which is made available by SkyLaw for informational purposes and should not be used as a substitute for professional advice from a lawyer.
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