This article is about using stock and stock options to compensate employees. This discussion applies mainly to the Canadian market and entities taxed by the Canada Revenue Agency (CRA). (see also articles on Incentive Stock Options and Market Options).

Whereas I used to be a big fan of incentive stock options, I now believe they should be used in moderation and primarily as a potential bonus mechanism. They are not a good substitute for shares or cash compensation for two main reasons: tax issues and because they may never be "in-the-money" (or expire before they are). They are also an accounting headache (only since 2005) because an artificial expense has to be determined theoretically (eg the Black-Scholes formula) when options are issued.

Normally, when a company is formed, the founders divide up the ownership among themselves based on their notion of fairness and their relative contributions (see notes on "Dividing the Pie").

However, as companies grow, they need to attract new talent. Virtually all companies - even the most mature big-cap blue chip firms provide compensation in the form of a salary and some form of equity participation. This is usually in the form of stock options.

For smaller, emerging entities, a huge (market-based) salary may not be possible. And, even when it is, most employees (at least in any management or senior responsibility capacity) like to be co-owners.

The challenge, then, is determining:
a) how much stock compensation (and its manifestation) and
b) the terms attached thereto.

Generally speaking, if the Company has not yet raised any capital from investors, it is easy tax-wise (and it is only for tax reasons that we may not just simply give shares because if they have any value they are taxed as income to the recipient) to include new people as founders unless the company has been around for a few years and/or is well advanced. In this case, the same dividing-the-pie discussion would be appropriate.

If the Company already has established some value by creating products, customers, revenues, etc and/or attracted investors who validate a company valuation by virtue of their investment (e.g the per share price that they pay multiplied by all the issued shares thereby yielding a "market cap" valuation for the firm), then it is, regrettably, not practical to just give a new-comer shares (because the recipient would have an immediate tax liability).

This is why stock options have been so popular, i.e. they get around this taxation problem. Make no mistake about it, though, they are NOT the same as equity ownership. For example, while the amount of tax paid when exercising options and selling the shares, is similar to capital gains taxes, profit from options is considered income, not capital gains. This means that one cannot offset other capital losses against such gains or if shares are held and sold at a loss, there is no capital loss relief against other gains. It also precludes the holder from participating in the $500K lifetime capital gains exemption (very important!).

For this reason, it makes sense to consider so-called Restricted Stock Units (RSU's) as an alternative to options especially for major participants. RSU's are grants of shares but with strings attached. Unlike options which are well defined and well understood, RSU's are newer, more complex varied. But the idea behind them is relatively simple. The company gives (or promises to give) a certain number of shares to an employee. These shares vest over time (just like founders shares should). Taxation questions need to be examined. For example, tax may not be payable until title to the shares actually passes to the holder.

One approach that's being taken by companies at the outset of their creation, is to allocate a certain percentage of the shares, e.g. 20%, to yet-to-be-recruited persons. This avoids a dilution later on and may get around some of the tax questions.

While the determination of how much stock someone should receive is largely a matter of negotiation, I like to start the negotiation by using a logical approach based on that person's contribution. As a side note, what I really like to see is such an employee actually making a cash investment in the company to acquire shares with no strings attached.

The idea of founders shares is that they compensate the holders for their hard work and intellectual contribution (i.e. that's why it's called "sweat equity"). If an experienced sales executive is being recruited, one can start with a competitive market rate for such a person. Let's say that she was earning (or could be hired by a mature firm) for $150K/year. If she agrees to work for $100K/year for 5 years, then the company needs to raise $250K less from investors and she should be entitled to that value in shares (say 500K shares if they are valued at $.50/share). That could also be augmented by a "signing bonus" amount. Since it is a promise to contribute, such shares should obviously vest over time (i.e. they are issued but subject to cancellation). The recipient needs to make sure that the deal is structured so that there's no tax liability until shares are sold.

If I were the new recruit, I would do my darnedest to get stock up front even if I have to pay some tax (if it tanks, I can recapture some of it later). For example - and this is typical - let's say Company X started up a year ago and raised a small amount of equity capital ($500K at $1/share) from various investors. One could argue that the shares have a value of either $1 or less if some time has lapsed with adverse results or more than $1 if time has passed with good progress being evident. In any event, the Company and I agree that the shares are worth $1 and I am "given" 200K shares subject to vesting and terms similar to the founders. In this case, which is the worst case scenario, the tax people would argue that I have received income of $200K on which I would have to pay normal income tax at my full marginal tax rate - which would be in the $90K range. Not good. If the company fails, I can only partially recover that $90K. And because I have to come up with $90K in the first instance, this may be a non-starter.

What I like to do is to simply buy shares at a negotiated price with no strings attached, ideally at a price much below the $1 figure, with some options thrown in to address the contribution/performance aspect. CRA might still challenge this, especially if the price is ridiculously low or if others are buying shares at higher prices at the same time. If you ask around, you will find that CRA rarely interferences in such private company transactions(ultimately, CRA gets its cut anyway when the shares are sold). It's a risk that many will take.

One reason why it is good to own real shares and get them early is because you get not only preferential capital gains tax treatment but in the case of private companies, you may be able to use the $750,000 lifetime capital gains exemption (don't overlook this!)

Don't take my word on it. Get your own "expert" tax advice on this. Ask more than one person. You may find that there are different opinions and degrees of conservatism out there, so you may have to make a judgment call.

For public companies, though, stock cannot be issued at a deep discount (small discounts up to 20%, depending on the Stock Exchange are permitted). In these cases, RSU's are becoming increasingly popular. In these cases, the stock is allocated but tax is avoided because title does not pass at the time of the grant.

In general, companies must understand that they will need to give up anywhere from 5% to 20% or more to deal in new people. Chief operating, financial, and marketing officers will expect a 10% equity participation in stock, options, or RSUs. (Note: RSU grants are usually smaller than option grants because of they always have real value regardless of the stock price.)

Directors of a Company, as a group, should receive the same compensation that a senior executive receives. As a rule of thumb, 1% to 2% ownership is common (with vesting, of course). Annual "refresh" grants are common.

With regard to terms, usually vesting or more accurately, reverse-vesting, over time is the most common term. For example, 100K founders shares may be given to someone on the condition that they contribute for at least 5 years. If that person quits (or is fired) after only one year, he would only get to keep 20K shares (ie. one-fifth). Vesting can occur in steps - monthly, quarterly, etc, but I prefer simple linear, daily vesting. Some vesting may take place only on the occurrence of a specific goal - product delivery, liquidity event, etc. Other terms that should apply are those that are spelled out in the Shareholders' Agreement, for example, the right to sell, right of first refusal, etc.

Bottom Line - equity is best! The challenge is to figure out who to make employees true owners - just like the founders - on an equitable and tax-free or tax-deferred basis!

Mike Volker is the Director of the University/Industry Liaison Office at Simon Fraser University, Past-Chairman of the Vancouver Enterprise Forum, President of WUTIF Capital and a technology entrepreneur. 

Copyright 2006-2007 Michael C. Volker
Email: mike@volker.org - Comments, suggestions and corrections will be appreciated!
Updated: 20070904