Business Basics for Engineers by  Mike Volker Stock Options (Incentive) Contact: Mike Volker, Tel:(604)644-1926,  mike@volker.org

This article is about Incentive Stock Options, not market stock options which are traded in the public markets. Incentive Stock options are often referred to as SARs - Stock Appreciation Rights. This discussion applies mainly to the Canadian market and entities taxed by the Canada Customs and Revenue Agency (CCRA).

There's rarely an occasion when stock options don't come up as a favorite conversation topic among high tech entrepreneurs and CEOs. Many CEOs view options as the way of attracting top talent from the USA and elsewhere. This article deals with the question of employee stock options mainly as they relate to public companies. However, stock options are just as popular with private companies (especially those planning a future public offering). 

Why not just give shares? In the case of both private and public companies, stock options are used instead of simply "giving" shares to employees. This is done for tax reasons. The only time when shares can be "given" without adverse tax consequences is when a company is founded, i.e. when the shares have a zero value. At this stage, founders and employees can all be given stock (instead of options). But as a company evolves, the shares grow in value. If an investment is made into the company, the shares assume a value. If shares are then just "given" to someone, that person is deemed to have been compensated at whatever the fair market value is of those shares and is subject to that income. But stock option grants are not taxable at the time of being granted. Hence, their popularity.

But, as much as I'm a big fan of options, I thought it might be useful to devote most if this article to explain what they are, how they work, and some very serious and onerous implications for both option holders, the company, and investors.

In theory and in a perfect world, options are wonderful. I love the concept: Your company grants you (as an employee, director, or advisor) an option to buy some shares in the company. An option is simply a contractual right given to the option holder (the optionee) whereby the holder has the irrevocable right to buy a certain number of shares in the company at a specified price. For example, a new recruit at Multiactive Software (TSX:E) could be granted 10,000 options allowing her (let's call her Jill) to buy 10,000 shares in Multiactive at a price of $3.00 (that's the trading price on the date of granting the options) anytime up to a period of 5 years.

It should be noted that there are no prescribed rules or terms associated with options. They are discretionary and each option agreement, or grant, is unique. 

Generally, though, the "rules" are:

1)the number of options granted to an individual depends on that employee's "value". This varies greatly from company to company. The Board if directors makes the decision as to how many options to grant. There's a lot of discretion.

2)the total number of options outstanding at any one time is generally limited to 20% of the total number of issued shares (in the case of Multiactive, some 60 million shares were issued, hence there could be as many as 12 million stock options). In some cases, the number can be as high as 30% and historically, the number has been around 10% - but that's increasing due to the popularity of options.

3)options are not granted to a company - only to people (although this is changing somewhat to allow firms to provide services).

4)the exercise price (the price at which shares can be bought) is close to the trading (market) price on the date of the grant. NB - although companies can give a slight discount, i.e. up to 10%, tax problems may arise (gets complicated!). 

5)technically, shareholders must approve all options granted (usually done by approving a stock option "plan").

6)options are generally valid for a number of years ranging anywhere from 1 to 5 years. I've seen some cases where they are valid for 10 years (for private companies, they may be valid forever once they have vested. Options may be the best way, tax-wise, through which new people can be brought on board, instead of simply giving them shares which have inherent value).

7)options may require "vesting" - i.e. if an employee gets 10,000 options, they can only be exercised over time, e.g. one-third get vested each year over 3 years. This prevents people from benefiting prematurely and cashing in before really having contributed to the company. This is at the discretion of the company - it is not a regulatory matter.

8)there are no tax liabilities (no taxes due) at the time when options are granted (But big headaches can occur later when options are exercised AND when shares are sold)

In the ideal scenario, Jill - the new technical recruit at Multiactive - gets right into her work, and due to her efforts and those of her co-workers, Multiactive does well and its stock price goes to $6.00 by yearend. Jill can now (provided her options have "vested") exercise her options, i.e. buy shares at $3.00. Of course, she doesn't have $30,000 in spare change lying around, so she calls her broker and explains that she is an optionee. Her broker will then sell 10,000 shares for her at $6.00 and, upon her instructions, send $30,000 to the company in exchange for 10,000 newly issued shares pursuant to the option agreement. She has a $30,000 profit - a nice bonus for her efforts. 

Jill exercises and sells all of her 10,000 shares on the same day. Her tax liability is calculated on her $30,000 profit which is viewed as employment income - not a capital gain. She gets taxed as if she got a paycheque from the company (in fact - the company will issue her a T4 income tax slip next February so that she can then pay her taxes in her annual return). But, she does get a little break - she gets a small deduction which equates to her being taxed on only 50% of her profit, i.e. she gets $15,000 of her $30,000 bonus tax-free. In this regard, her gain is treated like a capital gain - but it is still considered employment income (why? Aha - good old CCRA has a reason - read on).

This is how CCRA sees it. Nice and simple. And, it often does work exactly this way. Stock options are often referred to as "Incentive Stock Options" by regulators such as stock exchanges, and they are viewed as a means for providing bonus income to employees.

They are not - as many of us would like to have it - a way for employees to invest in their company. Indeed, this can be extremely dangerous. Here's a real example - many technology entrepreneurs got caught in exactly this situation. Just to be sure, I checked with the good folks at Deloitte and Touche and they confirmed that this situation can, and does, occur (often!).

Jim joins a company and gets 10,000 options at $1. In 5 years, the stock hits $100 (really!). Jim scrapes together $10,000 and invests in the company, now holding $1 million worth of shares. In the next 2 years, the market tumbles, and the shares go to $10. He decides to sell, making a $90,000 profit. He thinks that he owes taxes on the $90K. Poor Jim! In fact, he owes taxes on $990k of income ($1M minus $10K). At the same time he has a capital loss of $900K. That doesn't help him because he has no other capital gains. So he now has taxes owing and payable of more than $213K (i.e. 43% marginal rate applied to 50% of the $990K). He is bankrupt! So much for motivating him with incentive stock options!  

Under the tax rules, the important point to remember is that a tax liability is assessed at the time when an option is exercised, not when the stock is actually sold. (note - in the USA, the benefit is limited to the excess of the selling price over the exercise price. In the USA, the benefit is taxed as a capital gain if the shares are held for one year prior to sale!)

Let's go back to the example of Jill buying Multiactive stock. If Jill wanted to keep the shares (expecting them to go up), then she would still be taxed on her $20,000 profit in her next tax return - even if she didn't sell a single share! Up until recently, she would actually have to pay the tax in cash. But, a recent Federal budget change now allows for a deferral (not a forgiveness) of the tax until the time when she actually sells the shares (up to an annual limit of only $100,000. The Province of Ontario has a special deal allowing employees to earn up to $1M tax free! Nice, eh?).

Suppose that the shares drop (no fault of hers - just the market acting up again) back to the $3.00 level. Worried that she might have no profit, she sells. She figures that she has broken even, but in fact she still owes about $8,600 in taxes (assuming a 43% marginal rate on her "paper profit" at the time of exercise). Not good. But true! Even worse, suppose that the stock drops to $1.00. In this case she has a capital loss of $5.00 (her cost on the shares - for tax purposes - is the $6.00 market value on the date of exercise - not her exercise price). But she can only use this $5.00 capital loss against other capital gains. She still gets no relief on her original tax bill. I wonder what happens if she never sells her shares? Would her tax liability be deferred forever?

On the other hand, suppose that the world is rosy and bright and her shares rise to $9 at which time she sells them. In this case, she has a capital gain on $3.00 and she now has to pay her deferred tax on the original $30,000 of "employment income". Again, this is OK.

Because of the potential negative impact brought about by acquiring and holding shares, most employees are effectively forced into selling the shares immediately - i.e. on the exercise date - to avoid any adverse consequences. But, can you imagine the impact on a venture company's share price when five or six optionees "dump" hundreds of thousands of shares into the market? This does nothing to encourage employees to hold company shares. And it can mess up the market for a thinly traded security.

From an investor's perspective, there's a huge downside to options, namely dilution. This is significant. As an investor, you must remember that, on average, 20% new shares can be issued (cheaply) to optionees.  

From the company's perspective, the routine granting and subsequent exercising of options can quickly compound the outstanding share balance. This gives rise to "market capitalization creep" - a steady rise in value of the company attributable to an increased stock float. Theoretically, share prices should fall slightly as new shares are issued. However, these new shares conveniently get absorbed, especially in hot markets.

As an investor, is it easy to find out what a company's outstanding options are? No, it's not easy and the information isn't updated regularly. The quickest way is to check a company's most recent annual information circular (available on www.sedar.com). You should also be able to find out how many options have been granted to insiders from the insider filing reports. However, it's tedious and not always reliable. Your best bet is to assume that you're going to get diluted by at least 20% every couple of years.

The belief that options are better than company bonuses because the cash comes from the market, rather than from corporate cash flows, is nonsense. The long term dilutive effect is far greater, not to mention the negative impact on earnings per share. I would encourage directors of companies to limit stock option plans to a maximum of 15% of issued capital and to allow for at least a three year rotation with annual vesting arrangements in place. Annual vesting will ensure that employees who get options do indeed add value. 

The term optionaire has been used to describe lucky option holders with highly appreciated options. When these optionaires become real millionaires, corporate managers must ask themselves if their payouts are really justified. Why should a secretary earn a half million dollar bonus just because she had 10,000 "token" options? What did she risk? And what about those instantly rich millionaire managers who decide to make a lifestyle change and quit their jobs? Is this fair to investors?

Stock option rules, regulations and the taxation issues that arise are very complex. There are also substantial differences in tax treatment between private companies and public companies. Furthermore, the rules are always changing. A regular check with your tax advisor is highly recommended. 

So, what's the bottom line? Whereas options are great, like most good things in life, I think they have to be given in moderation. As much as stock options can be a great carrot in attracting talent, they can also backfire as we've seen in the above example. And, in cases where they do really achieve their purpose, investors could argue that humungous windfalls may be unwarranted and are punitive to shareholders. 

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

Copyright 2000-2003 Michael C. Volker
Email: mike@volker.org - Comments and suggestions will be appreciated!
Updated: 030527