When business participants hear of stock options and other forms of equity-based compensation, the tendency is to associate them with public companies. As an auditor of public companies, I can certainly attest to their common place existence. In another role as advisor to private companies, I’m starting to see more of these compensation arrangements in a private company context.
There is no shortage of opinion as to why this might be. Many point to the need of private businesses to stay labour competitive; think attracting and retaining talent given increasing global competition – often from public companies. Others highlight the capability of such plans to incent employees and preserve, or at least manage, precious cash flow – essential for start-ups and other cash strapped businesses.
These and other factors aside, the basic thinking behind these plans is that by granting ownership (or in certain cases the potential for ownership) to employees, their interests and motivations will become more aligned with the majority owners.
As we move onto the four broad forms these plans tend to take, keep in mind much of the functioning and key considerations are the same for public and private companies.
Stock Option Plans
In its simplest form, a stock option permits a holder to purchase stock in a company, at a stated price, for a stated duration. On option grant, the exercise price tends to exceed the value of the underlying shares, so as to incent the holder to do their part to up the price.
Stock options can be attractive to holders as there is no upfront cash outlay or tax implications nor is there any obligation to act.
Owners accept the dilution for the upside of the stock price moving in the right direction. Cash into the treasury doesn’t hurt either.
Stock Bonus Plans
At is simplest, a stock bonus is a bonus paid in company shares rather than cash. To incent employees, these bonuses tend to be tied to superior company and/or employee performance – or alternatively at the discretion of ownership with an understanding they will be paid during rosier times.
No different than with stock options, owners accept the dilution for the sake of improved operations and/or share price.
A straight share receipt will generally trigger an income inclusion for the recipient. For this reason, employees may view stock bonuses as more of a curse than a blessing – particularly if future sale options seem far off and/or likely to yield little value. Future liquidity events are much more of a challenge for private companies.
Stock Purchase Plans
At its most basic, a stock purchase plan allows employees to purchase company shares on prearranged date(s). To sweeten the deal for employees, shares are often sold at a discount to market and/or include an employer match component.
The foremost upside for owners here is the additional source of financing.
From an employee’s perspective, they may share the same future liquidity concerns as above. That said, there is no requirement to transact if they see no compelling reason to do so – which in-turn would beg the question: has alignment really been achieved?
Phantom Stock Plans
A phantom stock plan is more accurately described as an “equity-like” form of compensation. In short, a phantom stock plan typically specifies a cash bonus, determined with reference to a company’s share price.
From the owner’s standpoint, alignment is achieved in the sense that employees are directly motivated to increase share value. There is also the upside of avoiding dilution which is of course counterbalanced by the cash going out the door.
Employees enjoy the simplicity of a straight cash payment. The downside of course being no opportunity to benefit directly in the value created from profitable company growth.
Considerations for Employees
- Is the valuation method for determining company share price reasonable?
- Does a mechanism exist to realize on the shares for full value? How likely is this to transpire?
- How long are the vesting/exercise provisions?
- What is the timing and extent of income inclusions?
- Are there rights to dividends? Are payouts at the full discretion of the owners?
- Will a future gain on selling shares qualify for the lifetime capital gains exemption?
- What rights to the equity instruments will I lose on parting ways with the company?
- What equity-based compensation are competitors offering their employees?
Considerations for Owners
To start off, we should acknowledge many considerations for owners will be the inverse of employees. For example, instead of factoring income inclusions, owners will be concerned with deductions from income.
- Will CRA take issue with the share valuation technique?
- How will share redemptions/buybacks (or similar liquidity transactions) be funded? How much control do I have over the timing?
- Am I giving up too much control which may slow down or block any of a future: business combination, go-public transaction, estate freeze or other reorganizations?
- What are the tax withholding and reporting requirements (i.e. T4 reporting)
- What are the costs of administering the plan? Don’t forget about professional fees.
- How do I feel about sharing the company financial information required of certain plans?
With all the moving parts and competing interests, it’s crucial for owners and employees to educate themselves ahead of putting such a plan in place. As the end goal is aligned business interests, an unequitable plan will not serve the long-term purpose of either party.
Our team at parker simone is experienced and current on taxation and general functioning of equity-based compensation plans. If you’re considering a plan from either angle, we’re here to help guide the process.
Pat Kenney, CPA, CA, is a senior manager with parker simone LLP and an eleven year veteran of the public accounting space. He is a self-described student of all things business, accounting, taxation, personal finance and current events (thank-yous to Steve Paikin and John Moore). Pat’s interest in sports and local organized runs was the driving force behind his existing stance as a fitness and wellness enthusiast at-large. Pat is active in community based volunteer work focused on financial literacy and was recently nominated for a CPA Canada volunteer award in this capacity.
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Tax laws surrounding equity-based compensation plans are complex and dynamic. Tax mentions in this article are general in nature and not meant to be authoritative. Individuals and companies contemplating an equity-based compensation plan should consult a professional tax advisor.