Employee Stock Options in Canada
By: David Hariri
Tags: Equity, Options, Private Equity, Startup, Stocks

Understanding the value of options in a startup is tricky. There is not a lot of good published information on the benefits and mechanics of stock options in Canada. In general, I’ve found that startups don’t always do a good job of explaining this part of employee compensation. This leaves many employees feeling like their options are worthless, which I don’t believe to be true.

Assuming you are being paid a market salary, option grants give you the upside of your companies growth for much less risk. Most people only own shares in established, public companies. Most people cannot change the trajectory of an individual investment’s performance. By owning options in the company you work at, you get both. And if things go well, you get both for pennies on the dollar.

Before we dive into understanding the mechanics of options I should mention a few things. Skip this at your own risk:

It would be a good idea to understand the terms of your options with a lawyer. A good founder or people team could do this with you too.

You should also consult a startup lawyer or tax professional or both. The former can tell you if the terms of your options are weird. The latter can walk you through the tax implications of using them.

In this article, I assume you’re an employee of a Canadian-controlled private corporation (CCPC). Ask the finance lead at your company if you fit that criteria.

With that out of the way, most Canadian startups that I know of use boilerplate contracts. This article surfaces the common parameters that companies change when issuing options.

I’ve found that the most helpful way of understanding an option is as a ‘ticket to buy a share of a company’. You can use an option to buy a share in your company any time you want, so long as it hasn’t expired. More on expirations later.

Options have a ‘strike price’ or ‘exercise price’. This is the price you agree to pay to convert the option into a share in your company. A strike price correlates to the ‘Fair Market Value’ (FMV) of a company at the time in which your options are issued. It’s not always exactly the same, but it’s usually a little less or a little more in either direction. Purchasing shares with your options is called ‘exercising’ your options. If a company is valued at $1M and issues 1M shares when you join, you can expect each of your options to have a strike price of around $1.

A great thing about options is that the price is fixed at the time they are issued. The strike price remains the same, even as the value of the company changes over time. If after two years, the value of that company increases to $10M, your options can still be exercised at $1 per share. That’s great news considering shares in the company are now valued at $10!

This, of course, works in the opposite direction too. If after a year, the company is worth $100,000, your $1 options are now worth ¢10. In this case, you don’t need to exercise your options. If the FMV of your options falls below the strike price, you haven’t lost anything other than opportunity.

You can exercise your options by paying the strike price at any time, as long as the options have vested (more on vesting schedules later). This will convert the option to a share in the company which you could sell to a private buyer or hold. You can’t sell shares in a private company in the public markets, but there are secondary markets for these kinds of transactions. Before you go to these markets, it’s worth talking to whomever manages shares of the company. There’s a good chance that investors in the company will be willing to buy the shares you would have sold on a secondary market for at least the FMV. Your company may also help you with the transaction.

Depending on when options are exercised, the taxes can be many multiples of the strike price. The CRA taxes the value of the shares you receive, not the options you vest. You don’t need to worry about taxes until you exercise your options, but it’s important to understand that if you convert your options to shares, you will be taxed on the value of the options, not the sum of the transaction.

As with all your favourite financial instruments, options come with a few conditions. The three most often manipulated conditions are ‘vesting schedules’, ‘cliffs’ and ‘expiries’.

Vesting schedules determine when your options vest (become yours). Startups never give you all of your options at once. That would be too risky in case you and the company were to part ways. Typical vesting schedules spread out the vesting of options over four years. Along the way, you may be issued more options as your impact grows at the company. These additional grants usually have there own vesting schedules.

‘Cliffs’ determine when the vesting of options starts. A four year vesting schedule typically has a one year cliff. This means that your options will start vesting after the first year. If you received 2000 options when you joined your startup, you would receive 500 options after every year. At the end of four years, you would have all 2000 options you were granted when you started.

‘Expiries’ determine how long you have to exercise your options. Options have an expiry which usually kicks in if you leave the company for any reason. This applies even when you get laid off, not just if you quit or are fired. If you leave your startup, the options that haven’t vested yet disappear immediately. The options that have vested start expiring.

It’s typical to see a 90-day expiry on options issued by startups. That means that if you’ve vested options and are laid off, those options have to be exercised by the expiry date. Hypothetically in 90 days from the date of your termination. That means that you’re likely looking at spending thousands of dollars to exercise those options. This is why some people buy their options as they are granted while they are employed.

Side note: At Ada, we felt uncomfortable about the 90-day expiries we were seeing recommended. We changed our expiries from three months to five years for employees who have been at Ada for 2 or more years. This allows our owners time to plan for the cost of exercising their options and allows us to ensure they’re well earned.

Sometimes startups get acquired. This is called an ‘acceleration’ event because it may make your vesting schedule shorter or completely collapse it. Startups all handle this differently, but it’s an important thing to understand. At Ada, all scheduled options vest during an acquisition, collapsing the vesting schedule. This honours the promise we made to our team in case the acquirer does not want to re-hire everyone.

Exercising your options have tax costs. If the company has done well, you pay taxes on the gain in value of the shares, not the strike price that you’re paying for the shares.

To use our existing example, if your strike price is $1, but the CRA thinks the value of the shares you’re purchasing is $10, you will pay taxes on $9 per share. Carrying that through, that’s $2000 to buy the shares, plus a tax rate applied to the $18,000 value of the shares. If that tax rate is 50%, you’re looking at an $11,000 bill for exercising your options. If you don’t have a buyer for those shares, you could be looking at a very big cost for exercising your options.

Startups issue more shares as they grow so that they can give more to investors and their team. This dilutes the value of existing options, but usually by less than the relative increase in share value. I say “usually” because sometimes founders have to raise cash at unfavourable terms.

If a company issues 1M shares at a $1M FMV, each share is worth $1. If, in a years time, they issue another 1M shares (for a total of 2M shares) then each share is now worth ¢50. That’s if the companies value didn’t change, which is almost never the case. Let’s say the companies FMV is valued at $10M at the time they issue that additional 1M shares. That would mean that the shares are now all worth $5 each (up from $1) yielding a healthy profit of 500%! It would be better if your shares were worth $10 each, but if the founders are smart, they’re diluting by an amount that captures future upside. That should (if everything goes right) be better for you in the long term.

When you exercise your options, the CRA will tax your shares as a capital gain based on the FMV of the company at that time. This means that if you pay a strike price of $1 per share, but shares are now worth $10, you’ll pay taxes on $9 per share. That’s a lot more than the $1 per share that you paid to buy them.

The tax cost is important to understand. Most people want to exercise their options when the value of the shares is high, but can’t afford to pay the taxes. If you’re most people, it’s usually wiser to wait until you have a buyer. That way you can exercise the options, sell the shares, and put aside the taxes all in one move. If the buyer is an active investor in the company, It’s possible your startup will even facilitate the whole transaction.

Canada recognized this issue and implemented a tax deferral program for this kind of capital gain. It allows you to defer the taxes when the options are exercised, as long as you hold the shares for at least two years and the FMV at the time of exercise is at least the same as the strike price. This is better, but still risky because you’ll be betting that the taxes now will be less than if you exercised your options later. If your company tanks in two years from when you purchased your shares, you will still owe taxes on the gains you made based on the FMV at the time you exercised your options.

Unless you are convinced that your company is going to be worth a lot more in at least two years from now, you would do well by waiting to exercise your options until the shares are being purchased during a liquidity event. Typical startup liquidity events include acquisitions, secondary sales or IPOs. It’s during these times that most employees exercise their options to purchase shares to then immediately sell.

You made it! I hope this helps you understand what options are, why they exist and how best to exercise them. If you have questions, I’ll do my best to answer them on Twitter.