Stock Options are a popular way for companies, especially startups, to compensate their employees. Although there is no guarantee of the success of a company, by fully understanding your stock options and specifically, the tax implications associated with them, you can avoid making common (and big) mistakes that can cost you thousands of dollars.
The most important things to understand are covered in this post: what they are, how they work and any tax implications you may come across.
Because reading your stock option agreement can be quite tedious and difficult to digest, here are the key things you need to understand before delving into the details:
What are stock options?
Stock options are given to you by your employer and they allow you to purchase a specified number of shares of the company at a fixed price (exercise price) during a fixed timeframe. With stock options, you will hold no shareholder rights, such as receiving dividends or voting. A contract sets out the terms, which include number of shares, vesting schedule, exercise price, and expiry date.
They are usually issued as an incentive for you to work hard to improve the company’s performance and in turn, the stock value. The higher the company value, the higher the stock price and therefore the larger the potential for personal financial gain.
One of the biggest caveats about stock options are the tax implications when it comes to exercising them, which we discuss in some detail below.
How stock options work
Firstly, it’s important to note that any value in the stock options is completely theoretical until you pay the exercise price to buy the shares.
There will usually be a minimum length of time you must work at the company before you can exercise your options, known as the vesting period.
Once this period has passed and you have exercised your options, you will own the shares just as you would if you had bought them like any other investor.
Types of Stock Options
There are different types of options you may be offered, so check your agreement to figure out which one yours fall under.
Stock option plan: You are given the option to purchase shares of the company at a predetermined price.
Employee stock purchase plan (ESPP): You can acquire shares at a discounted price that is less than the market price at the time of acquisition. Most ESPPs require you to work for the company for a certain amount of time before you can acquire the shares.
Stock bonus plan: You receive company shares free of charge.
If you have been issued options under a stock option plan (which is the most common of the above types) and the market value of the stock increases, you will still only pay the price per share noted in your stock option agreement.
This price is known as your exercise price.
For example, if you were granted 1,000 stock options at $10 per share when you started, even if the stock price has risen to $50, you will still only pay $10,000 (1,000 shares at $10 each) vs. their market value of $50,000.
In this case, you would receive a financial gain of $40,000 (subject to tax implications, discussed below).
How is the price I receive determined?
For private company options, the exercise price is often based on the price of shares at the company’s most recent funding round. If it is a public company, then usually the strike price is equal to the stock’s market value at the time the option is granted (but not always).
Underwater Stock Options
Of course, if you’re working within a startup, there is often no guarantee that the company will succeed.
Sometimes employee stock options might have no value. This happens when your exercise price is higher than the current market price of the shares. When this happens, your stock options are said to be “underwater”.
During times of stock market volatility, employees of publicly traded companies may be allowed to exchange underwater options for those that are in money – since the company is legally allowed to cancel the first option grant and issue new options exercisable at the new share price.
Your company will determine what type of vesting period you have. By knowing how the vesting period works, you will be able to figure out exactly how long you need to wait before you can exercise your options.
These are the three ways your options could potentially vest:
1. Time-Based Vesting:
95% of companies that offer stock options use this type of vesting period. In this case, your options typically vest upon completion of a specified time period – usually 3 to 5 years. To add to the complexity, there are also two ways they may vest: all at once (Cliff Vesting), or in parts over a few years (Graded Vesting).
Cliff Vesting: When the option grant vests all at once, i.e. you have to wait the full length of your vesting period before you are able to exercise any of your stock options.
Yearly Graded Vesting: When the options grant vests in a series of parts over time i.e. you may get 25% in your first each year over a period of 4 years until the specified timeframe is up.
One Year Cliff & Monthly Graded Vesting: When the options vest at 25% at the end of the first year and the remaining 75% vest monthly (or quarterly) over the next three or four years. This is typically seen in early stage startups. So if you have a monthly vest with a one year cliff and you leave the company after 18 months, you’ll have vested 37.5% of your stock.
Example of Yearly Graded Vesting:
2. Performance-Based Vesting:
Options vest upon the achievement of a performance condition such as a financial metric or a specific share price.
3. Time-Accelerated Vesting:
A combination of time-based and performance-based vesting periods. With this method, your options are time-based, but if a predetermined market condition is achieved prior to the time-based requirement then this is accelerated.
Stock options always have an expiry date. The most common period is 10 years from the date of grant.
So, if you have a 4 year vesting period and the expiry period is 10 years, then you will have 6 years left to exercise your options after your vesting period.
Make sure you exercise your options before the expiration of the grant term. If you do not, you will permanently forfeit them.
Understanding the tax implications of owning and exercising your options is essential to ensuring that you keep as much of the money generated by your options as possible.
There are two pieces of taxation to consider when exercising stock options.
1. When you exercise the options
The difference in the exercise price and the fair market value (FMV) on the date the options are exercised is taxed as employment income.
For example, if you had 10,000 options with an exercise price of $1.00 and the FMV of the shares on the exercise date was $3.00, the taxable benefit would be $20,000. In most cases, you can claim a deduction equal to 50% of the taxable benefit.
2. After you exercise the options and hold the shares
Any gains or losses are treated no differently than if you purchased the shares on the open market. The FMV of the shares on the exercise date becomes the cost base for your shares.
Continuing with the example above, if the current share price is $7.00 and your cost base is $3.00, you have a capital gain of $4.00 per share. On your 10,000 shares, your total gain is $40,000. In Canada, you pay tax on half of that gain, which would be $20,000.
For Private Companies
If your company is a CCPC (Canadian-controlled private corporation), the taxable benefit you realize when exercising the options can be deferred until you sell the shares if you hold the shares for at least 2 years before you sell them.
Unlike with public companies, the exercise price and the FMV on the grant date do not have to be equal.
Lifetime Capital Gains Exemption (LCGE)
CCPC shares are often eligible for a lifetime capital gains exemption (LCGE), meaning you pay no tax on any gains up to that amount. In order to qualify for this exemption, the company must be a CCPC when you sell the shares. If your company is going public, make sure you file the appropriate form (T2101) with CRA to make a deemed disposition of some or all of your shares as of that date. You don’t actually sell the shares, you are just recording the gain for tax purposes to take advantage of the exemption.
The LCGE for 2015 is $813,600, so you don’t want to miss out on that if you are fortunate enough to have a gain that big.
For Public Companies
Make sure that the exercise price on your options was equal to the FMV on the grant date. If it is not, then your shares are not eligible for the 50% deduction. Unlike for CCPCs, the taxable benefit cannot be deferred, it is taxable in the year the options are exercised. Also, the LCGE does not apply to public company shares.
What if you leave before the vesting period is up?
At the time you leave the company, you’ll want to understand how your departure affects the exercisability of your options to minimise any loss to you.
If you leave before the vesting date, you will either have to forfeit your options, or will have a short time period (typically 60 – 90 days) to exercise.
In other cases, when major job or life events occur such as disability or retirement, certain rules may be triggered under the plan.
What happens if the company is bought or goes public?
With an IPO, nothing changes with regards to your actual stock options (vested or unvested) other than the shares you can buy with them are now easier to sell. Sometimes there will be what is called a ‘lock-up’ period, meaning you have to wait 6 – 12 months after the IPO before you can sell your shares.
If the company is bought, your stock options will likely carry forward – exactly how they do so will be determined by the transaction on a case-by-case basis. In most scenarios, your options should be treated similarly to common shares.
Refer to the tax section above to review the tax implications of private companies going public companies.
What if you want to exercise on departure and the company is still private?
Usually if the company is still private, it is difficult to determine the fair market value of any shares to be received on exercise of an option. The value will be a best guess based on the last round of investment, or a valuation agent will determine the value of the company.
Any sale in this situation may be subject to a right of first refusal. This means your company or any one or more of its shareholders have the right to purchase the the shares at the price that was offered to you – or in some cases, a different price.
So, if you do decide to exercise your option upon leaving the company, you should first understand what rights, if any, the employer has to “recapture” your shares and on what terms.
How do you pay?
Stock plan rules for exercising will vary by company and there are three ways they can be exercised:
Make a cash payment – (Yes, you have to come up with the full cash amount.)
Pay through a salary deduction
Sell immediately in a cashless exercise – You do not need to provide the cash to exercise the option upfront, but instead you can use the equity built up in the option. In other words, you can use the difference between the market value and the exercise price as a way to exercise the option.
Should you exercise right away?
Once your options have vested, try not to succumb to the desire for instant gratification and jump into exercising and selling your shares. In the long-run, it can be a mistake and your actions should be dictated by your stock option strategy.
An important consideration to make when you exercise your options is to think about the affect they will have on your overall asset allocation (if you currently have an investment portfolio).
For your investment planning to be successful, it is important for your assets to be appropriately diversified and therefore should be aware of any concentrated positions in the company’s stock. Many advisors recommend that no more than 10-15% of your net worth be in your company’s stock. If you are in a senior position with the company, a limit that low may not be practical. An experienced financial advisor can help you manage the risk of a concentrated stock position.
How are stock options different from RSUs?
RSUs (Restricted Stock Unit) are sometimes given instead of stock options. An RSU is valued in terms of the company’s stock, like a stock option. However it is unique in that it does not have an exercise price. This usually means that you do not own the RSUs until the vesting period (the same as the vesting period on stock options) has been met. At this time, they are assigned their current market value and are considered income. Since they’re considered income, a portion of the shares are withheld to pay income taxes. You then receive the remaining shares and can sell them whenever you like.
So, if you were granted 10,000 RSUs, you do not own these shares until the company hits a defined performance condition, such as an IPO. Once that defined period is hit, the company will deliver the 10,000 shares or cash equivalent of the number of shares.
Hopefully this article has helped you more thoroughly understand your stock option agreement. If you have any questions, don’t hesitate to reach out in the comments below!